Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching the Wage-Price Spiral Again
Transcript
- Lucas: So the term 'wage-price spiral' is getting thrown around in central bank speeches again, and I think a lot of people hear that and picture their grandparents telling stories about the seventies. But the reason it's back in the conversation right now — mid-2026 — is that we've got a labour market that's been tight for years, services inflation that's been stubborn, and a bunch of central bankers who are genuinely worried that if wages keep running hot, companies will keep passing those costs along, and then workers will demand even higher wages to catch up. Luna: Right, the classic doom loop. But haven't we been hearing for years that the wage-price spiral is dead? That globalisation and technology and weaker unions broke it forever? Lucas: That was definitely the consensus coming out of the 2010s. You had the Phillips curve looking flat, inflation staying low despite tight labour markets, and a lot of economists — including some at the Fed — argued that the structural forces had changed. But then you get the post-pandemic inflation shock, and suddenly wages are rising four or five percent a year, and services inflation is hanging around three plus percent, and central banks start asking: is this just a temporary pass-through, or is it the start of something more circular? Luna: And what's the specific data point that's got them spooked? I know the Atlanta Fed has that wage tracker. Lucas: Exactly. The Atlanta Fed Wage Tracker has been hovering around five percent year-over-year for most of the last two years. That's the headline number. But the deeper concern is unit labour costs — which is wage growth adjusted for productivity. If productivity is growing at one and a half percent and wages are growing at five, unit labour costs are up three and a half percent. That's way above the two percent inflation target. And if companies pass that through to prices, you get exactly the spiral dynamic. Luna: So the productivity number is the swing factor. If productivity were higher, you could have higher wages without inflation. Lucas: Exactly right. And that's the optimistic scenario — the AI boost, the reshoring investment, all that could lift productivity. But we haven't seen it in the official data yet. Nonfarm business productivity in the US grew at about one point two percent annualised in the first quarter of 2026. That's not bad, but it's not enough to absorb five percent wage growth. Luna: So the Fed sees that gap and worries. But what about the other side — the argument that profit margins are the real story, not wages? Lucas: That's a really important counterpoint. Some economists, including Isabella Weber, have argued that what we're seeing is more of a 'sellers' inflation' — companies using the excuse of higher costs to boost margins. And there's truth to that. Corporate profit margins in the US are still historically high. But from a central bank perspective, the wage channel is the one they can actually influence through monetary policy. They can't directly tell companies to cut margins. So they focus on wages as the durable driver. Luna: And the ECB is in a similar boat? Euro area wages have been running hot too. Lucas: Yeah, the ECB has been laser-focused on negotiated wages. They were up about four and a half percent year-over-year in the first quarter. That's actually slowed a bit from last year's peak, but it's still well above what Christine Lagarde considers consistent with two percent inflation. And the worry there is that services inflation — which is very wage-sensitive — has been stuck around four percent. So the ECB is basically waiting to see wage moderation before they feel comfortable cutting rates further. Luna: And the Bank of Japan — different story, right? They've been trying to generate a wage-price spiral for decades. Lucas: Yes, that's the fascinating contrast. The BOJ has wanted positive wage growth and inflation for thirty years. Now they're finally getting it — the spring wage negotiations in 2025 delivered over five percent wage increases, and 2026 looks similar. But for them, the spiral is actually desirable — it's a sign they've escaped deflation. The problem is that it might overshoot. If wages and prices start feeding each other too aggressively, the BOJ might have to raise rates faster than they want, which could destabilise their bond market. Luna: So every central bank has its own version of the concern. But going back to the US — how does the Fed actually measure whether a spiral is happening in real time? They can't wait for the data to be revised two years later. Lucas: They look at a few things. One is the Employment Cost Index — that's the Fed's preferred wage measure because it controls for compositional shifts. Another is the Atlanta Wage Tracker we mentioned. But probably the most important is the relationship between wage growth and inflation expectations. If workers expect high inflation, they demand higher wages, and that becomes self-fulfilling. So the Fed watches the University of Michigan survey of consumer inflation expectations very closely. If the one-year-ahead expectation breaks above four percent and stays there, that's a red flag. Luna: And where are those expectations now? Last I saw, they were around three percent for one year, which is elevated but not crisis level. Lucas: Correct. Three point one percent in the June 2026 survey. That's above the two percent target, but it's not the kind of de-anchoring that would trigger an emergency rate hike. The five-to-ten-year expectations are still well anchored around two point three to two point five percent. So the Fed's view seems to be: we're not in a spiral yet, but the conditions are such that we need to remain vigilant. Luna: That makes sense. But I want to push on something: isn't the whole concept of a wage-price spiral a bit outdated? I mean, in the 1970s, you had cost of living adjustments built into union contracts, which mechanised the spiral. Today, union coverage is much lower, and contracts are shorter. Lucas: That's a really good point. The institutional structure is different. In the 1970s, about a quarter of US workers were unionised, and many had formal COLAs. Now it's around six percent. So the automatic pass-through is weaker. But that doesn't mean it can't happen. If labour markets are tight enough, workers can quit and find a higher-paying job without a union. That churn can push up wages across the board. The mechanism is less formal but still real. Luna: And we've seen that churn. Quits rates were elevated for years. They've come down, but they're still above pre-pandemic levels. Lucas: Right. And the other structural change is that services are more labour-intensive than goods. So when the economy shifts toward services, wage costs become a bigger share of overall costs. That makes the pass-through from wages to prices more direct. That's why central banks are so focused on services inflation right now. Luna: Before we go further — and this is a bit meta — a lot of what we're talking about is made possible because our listeners support the show directly. We don't run ads, we don't have sponsors, it's just us and our listeners. And if you've found these explanations useful, you can help keep it going at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small but really meaningful group that makes this possible. And it keeps us free to dig into topics like this without having to dumb anything down. So thanks to those who already chip in. Luna: Alright, back to the spiral. So the Fed is watching wages, productivity, and expectations. But what's their actual policy posture? Are they still in 'higher for longer' mode? Lucas: The Fed has held rates steady at five and a quarter to five and a half percent since December 2025. The dot plot from the June meeting showed one or two cuts projected for the second half of 2026, but that's contingent on inflation continuing to moderate. And the wage data is one of the key variables that could delay those cuts. If unit labour costs stay elevated, the Fed will hesitate. Luna: So the risk is that a wage-price spiral doesn't have to fully materialise to affect policy — just the fear of it can keep rates higher. Lucas: Exactly. And that's the tricky part for central bankers. If they act too aggressively based on the fear of a spiral, they might overtighten and cause unnecessary unemployment. If they act too late, the spiral takes hold and they have to raise rates sharply later. It's a classic risk management problem. Luna: And what about the global dimension? If the Fed keeps rates high, that strengthens the dollar, which imports disinflation to other countries. But it also tightens financial conditions globally. Lucas: Yes, the dollar has been strong through 2026, partly because of the Fed's stance. That helps other central banks by lowering their import prices. But it also creates challenges for emerging markets with dollar-denominated debt. The IMF has been warning about spillovers. So the wage-price spiral is not just a domestic issue — it's interconnected. Luna: Let me ask a hypothetical. Suppose we get a productivity boom from AI — say two and a half percent annual growth for a few years. Does that make the wage-price spiral impossible? Lucas: It makes it much less likely. If productivity is growing at two and a half percent, then wage growth of four percent is consistent with unit labour costs rising only one and a half percent. That's well within the target. So the key question for the next few years is whether the productivity data actually shows up. There's a lot of optimism, but the official statistics are lagging. Luna: And if it doesn't show up, we're back to the same tension: tight labour markets, sticky services inflation, and central banks on alert. Lucas: Exactly. And that's where we are right now — waiting. The wage-price spiral is more of a risk than a reality. But the fact that central banks are talking about it so much tells you they think the conditions are ripe. It's a reminder that the low-inflation era of the 2010s might not be the new normal. We might be in a more volatile regime where the old dynamics matter again. Luna: So the bottom line: the wage-price spiral is back on the radar, not because it's happening, but because the ingredients are there. And the central banks are determined to prevent it before it starts. Lucas: Right. And that determination itself is a big part of the story. The credibility that central banks built over the last forty years gives them a head start. But credibility isn't permanent. You have to keep earning it. Luna: And that's the challenge for the next year or two. Thanks, Lucas. Lucas: Thanks, Luna. Good discussion.