ECB Forum on Central Banking: Price and wage-setting in advanced economies
- Presentations and discussions hoover around the “Phillips curve”, the pivotal concept justifying the existence of central banks
- Draghi stresses that wages are finally rising and the Phillips curve is strengthening
- The Phillips curve is “alive and well but needs to be found” as measurement errors have likely overshadowed inflation signals
- Nowadays, Phillips curves contain inflation expectations which should be influenced more directly in breaking the “veil of inattention”
The ECB Forum on Central Banking is a big, high-profile get-together of economic researchers and central banker from around the world. Last week in Sintra, Portugal, the main topic was price and wage-setting in advanced economies.
In the opening remarks, ECB President Draghi commented on the economic outlook for the Euro Area and the monetary policy decisions which were recently taken by the ECB. He acknowledged that growth has moderated so far in 2018 and talked about supply-side and demand-side factors to judge whether the moderation has any bearing on medium-term growth. On the supply-side of the Euro Area economy, there are increasing signs of capacity constraints. Economists usually distinguish between three production factors (“supply-side”): Labor, capital and technology. Labor has contributed substantially to economic growth so far. The labor force participation rate increased by 1.5 %-age points since the crisis and employment has been expanding by 8.4 million persons since mid-2013 in the entire Eurozone. On the other side, there has been a lack of capital deepening contributing approximately zero to the current economic expansion. The lack of investment in fixed capital (machines, factories, etc.) could be one reason why the economy hit capacity constraints and, as Draghi said, firms should increasingly turn to capital to lift capacity. The demand-side – in particular the “virtuous circle between employment and consumption” – remains robust and “the main motor of the expansion”. However, uncertainty surrounding the outlook has recently increased.
For monetary policy, the key issue is how growth feeds into wages and then inflation; i. e. the headline topic of the conference. The reaction of inflation dynamics to accelerating growth has been atypically slow in recent years. Draghi thinks that the Phillips curve relationship – the pivotal concept gauging the relationship between real economy variables (unemployment, output) and wages and prices - has been strengthening recently. Compensation per employee is now growing at 1.9 % annually and negotiated wages also started to drift upwards (Figure 1 - see pdf).
That said, higher wage growth does not mechanically translate into higher inflation and structural factors can impede the transmission of wages to consumer prices (for example, competition through globalization or e-commerce). For example, we estimated for the US, that the transmission of wages to consumer prices is less than proportional and can take around a year. During the rest of the opening remarks President Draghi mainly summarized the monetary policy decision of the last meeting of the governing council.
The low rates of price inflation in both the US and the Euro Area have been resistant to tightening economic conditions. One possibility is that the unemployment rate might understate slack because of special features of the financial crisis, recession and the long recovery. James Stock (Harvard) and Mark Watson (Princeton) presented evidence that the same puzzling quiescence of inflation remains when they look at other slack measures (for example, the short-term unemployment rate). The current regime of largely stable rates of inflation, the combination of measurement noise and special factors makes it particularly hard to observe the “signal” of inflation. Stock and Watson deconstruct price indexes at the sectoral level and exclude the most poorly measured price series to look at cyclical sensitivity. They find that cyclically sensitive inflation has increased in the US from 2.1 % to 2.6 % (while actual core inflation was unchanged at 1.5 %), but in the Euro Area these most cyclically sensitive components of inflation remain quiescent. Lucrezia Reichlin (LBS) – the discussant of the panel – concluded that “the Phillips curve is alive and well but needs to be found”.
In this respect, James Bullard, the President and CEO of the Federal Reserve Bank of St. Louis, argues that improved monetary policy has caused the empirical Phillips curve to disappear. The actual, or structural, Phillips curve, however, is well and alive. The credibility of modern central banks to react aggressively to deviations of inflation from target reduces the slope of the Phillips curve. Hence, it is no coincidence, so President Bullard, that the Phillips curve has flattened when policymakers put more weight on inflation deviations.
Nowadays, Phillips curves usually include an inflation expectations term incorporating the forward-looking nature of economic decisions. “Anchoring” inflation expectations is key for central banks. Yuriy Gorodnichenko assessed whether central banks should use inflation expectations as a policy tool for stabilization purposes. Inflation expectations are a key size in monetary theory and policy. Inflation expectations determine inflation once economic agents are forward-looking or, put simply, incorporate expectations about their economic future into current decisions. When inflation expectations are “anchored” (by the central bank around its target), moving the key interest rate changes the real interest rate. Changing the real interest rate affects households’ and firms’ decision plans (consume or save?, borrow and invest?). Higher inflation expectations induce firms to raise their prices and workers to demand higher wages. Empirical evidence suggests that inflation expectations of households and firms affect their actions but the underlying mechanisms remain unclear. According to Gorodnichenko, available surveys of firms’ expectations are systematically deficient, which can only be addressed through the creation of large, nationally representative surveys. It is not quite clear to what extend households’ or firms’ expectations respond to changes in inflation expectations (“veil of inattention”) though in general they should update their believes. Experience and perceptions of inflation as well as shopping are assumed to influence strongly the economic agents’ expectations about inflation. Breaking through the “veil of inattention” means for policymakers to repeat their messages (one-time announcements) and conduct information campaigns about simple messages. “Take the message directly to the audience”, Gorodnichenko says. Conventional media might not be good enough; one could also target social media, as, for example, the ECB has been doing on Twitter. Policymakers should use households’, firms’ and financial markets’ expectations. A prominent example for indicators for inflation expectations for the Euro Area is the Survey of Professional Forecasters (SPF) that is conducted on a quarterly basis by the ECB. Investors express their views in financial market instruments such as the 5 years forward inflation swaps, which are, in turn, closely followed by financial market participants (Figure 2 - see pdf).
Authors
Martin Ertl Franz Zobl
Chief Economist Economist
UNIQA Capital Markets GmbH UNIQA Capital Markets GmbH
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