Some weeks ago, Bank of England Governor Bailey made a forlorn plea for wage restraint. 

Some weeks ago, Bank of England Governor Bailey made a forlorn plea for wage restraint. Data this week showing that average earnings growth has risen to 7% in March suggests that nobody is listening. And why should they with inflation now 9% and set to rise above 10% on the Bank’s own forecasts? The problem for the central banks is that they may be a victim of their own success. What we mean by this is that decades of low inflation have meant that they have not had to act like “inflation nutters”, to use former BoE Governor King’s words, and impose tough financial discipline. Inflation has tended to ease down from above-target levels after fairly modest tightening – and often with the help [sic] of a recession (as we saw in the global financial crisis, for instance).

But a problem with not having to be too tough on inflation may mean that now the public does not really believe them when they say that they will have to be tough in the future given that inflation is so high. And, if the public does not see much threat of higher policy rates if they demand and achieve high wage awards, then they are likely to ignore the advice of Bailey and others.

There was a time in the past, if we go back into the 1980s and 90s for instance when central banks worked hard to acquire strong anti-inflation credibility. The German Bundesbank, for instance, got itself into a position of powerful anti-inflation credibility, so much so that the huge inflationary shock of German reunification in 1990 was quite easily managed by the Bank.

In fact, at the time economists even started to talk about a timeinconsistency problem for the Bank. In this situation, the Bundesbank was thought to have such strong anti-inflation credibility with the public that if it even as much as warned about tighter policy in the event of inflationary wage awards, the public would respond by keeping wage demands down. The time-inconsistency arose because, by the time it came for the Bundesbank to lift rates, its jawboning had already worked to the extent that rate hikes were no longer needed. The danger in this was thought to be that if the Bank kept threatening rate hikes but never delivering it would eventually lose its anti-inflation credibility. Thirty-two years on and you can say that’s exactly what’s happened even if it is largely because the Bundesbank is no longer in control of policy anymore, it is the ECB.

The difficulty as well for these central banks, particularly the Fed and the Bank of England is that people don’t really fear unemployment because the labour market is so tight. Hence, if they can’t get the wage rise they want in their job they can move to another job. Indeed, there’s been some uproar in the UK when a government minister addressing the cost-ofliving crisis said that people should move to higher paid jobs.

“That was seen as insensitive but does reflect the reality at the moment and, in our view, it is likely to keep wage growth very elevated and so produce those dreaded ‘second round’ effects that central bankers fear, particularly the ECB which has not seen such sharp wage rises in the euro zone yet”, Mr. Steve Barrow, Head of Standard Bank G10 Strategy said.

The bottom line is that past anti-inflation credibility of central banks may not count for much given the extent of the rise in inflation and the misjudgement of the central banks have already made, and the tightness of the labour markets. Breaking the wage/price spiral will take a deeper slowdown and higher policy rates than most seem to be assuming right now.