Higher wages adding fuel to raging inflation fire

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Mckinsey’s latest global economic conditions outlook gives an idea about actions taken by the central banks and future prospects of economy.

It’s a common perception that high commodity prices due to supply-side issues (war, lockdown, bottlenecks in ports) are the main reasons for inflation.

However,  as second order effect of higher commodity prices, workers started asking for higher wages. That’s a major issue in North America.

As per Mckinsey, wages have a maximum contribution to costs increase in US and India. While in Europe energy prices are major cost contributors.

Another interesting point is that executives across the world consider inflation to be the biggest risk to the economy, followed by geopolitical instability. While in Europe, volatile energy prices are considered as the biggest risk.

However, supply chain disruption are way down the list of major risks. The labour shortage is also not a major concern except in the US. In fact, even interest rate hikes haven’t worried executives that much.

This justifies why Fed started the rate hike cycle pretty quickly while ECB was very late in joining the party. Labour shortages are a major concern in US and wages have a maximum contribution to cost increas,  translating into higher bargaining power of labour.

That’s why Fed is increasing the rates to keep inflation expectations anchored. High-interest rates will indicate to workers that inflation will eventually subside and they won’t ask for a huge increase in wages. That would prevent a wage spiral.

Since labour shortage is not major issue in Europe, therefore ECB hiked rates much later.

Let’s connect the dots. Inflation was majorly triggered by supply chain disruptions and now as per executives, it is cooling off. So, if it is not such a big concern then it also suggests that inflation will cool down if the wage inflation spiral is prevented.

Inventories in US, as well as EU, have shot up in recent times. This will further catalyse the fall in inflation (companies will reduce prices to reduce inventory levels). If inflation cools quickly, then a lower unemployment rate will ensure quicker demand revival which will trigger economic growth.

So, the UN might ask Central banks to stop rate hikes, but that’s the bitter pill we need to cure stagflation.