Feeding the inflation monster – wages

Last Updated on Thursday, 28 September, 2023 at 9:13 am by Andre Camilleri

Silvan Mifsud is director of Advisory at EMCS Tax & Advisory and also a council member of The Malta Chamber

The notion of a living wage or an improved minimum wage gains momentum during a period of high inflation. This happens as people with low wages see their limited purchasing power eroding even more. Hence, why, in such inflationary periods, the question of increasing minimum wages becomes more topical.

However, let us start from the very basics. To make economic sense for any employer, wages should not be higher than the value produced by the same employees. Keeping this principle in mind, while the argument of increasing minimum wages, especially during inflationary periods gains momentum, one has to also understand that higher wages also mean higher costs, which ultimately means that companies will pass on these wage increases to the consumer, feeding inflation, and thus possibly eroding the purchasing power of workers. That is the same dilemma with broader wage inflation indexing we have in the form of COLA.

The research literature presents a variety of results on the link between wages and prices. For example, the research by Bobeica et al. (2019) in the euro area provides empirical evidence of the link between labour costs and price inflation in the period 1985-2018. The results of this study show that the pass-through of labour costs to price inflation is more likely during demand shocks than supply shocks and that this pass-through is systematically lower in periods of low inflation than in periods of high inflation. Another research study by Druant et al. (2012), outlines results of an extensive survey of firms in the euro area show that there is evidence of a pass-through of wages to prices, especially in the case of firms with a high labour cost share. The end result of this study is that a statistically significant relationship is found between the frequency of wage changes and that of prices with over 60% of firms reporting that they would increase prices if they faced a permanent increase in wages. This brings about the issue of competitiveness. When labour costs grow faster than productivity or labour costs in other countries, competitiveness is reduced. This may jeopardise the success of the economy’s tradable sector on international markets and erode the potential for long-term growth.

All the above was outlined in the recent Outlook for the Maltese Economy publication issued by the Central Bank of Malta, whereby it stated: “In view of the current high inflationary pressures, as well as tight labour market conditions, nominal wage growth is projected to be relatively strong from a historical perspective. Compensation per employee is thus set to grow by 5.5% in 2023, 5.7% in 2024 and 3.9% in 2025. Indeed, this will outpace consumer price inflation during the last two years of the projection horizon as consumer price passthrough to wages is projected to occur with a lag. A persistently negative employment gap implies that labour market tightness will remain a factor that could limit economic growth going forward, albeit less than before. This easing of labour market tightness should also dampen upward pressure on wages by 2025.”

This means that as the Central Bank outlines, the decisions we take now that can increase labour costs will keep effecting the whole economy with a time lag. We also have to keep in mind other relative recent factors that are affecting inflation and labour costs. One emerging element is the new view of work-life balance which has changed in a post-pandemic world. This will likely keep effecting the labour market tightness. One thing remains crucial: Malta’s competitiveness. Among the various statistics issued by Eurostat on the labour market, one finds the Labour Cost Index. The Labour Cost Index is one of the principal European economic indicators, which shows the short-term development of the labour cost based on the total cost on an hourly basis of employing labour. The data on the Labour Cost Index is given in the form of index numbers (current base year: 2020) and as annual growth rates (comparison with the previous year). As shown below, the Labour Cost Index for Malta has been showing annual growth rates in labour costs that for all years from 2013 onwards, except for 2016 and 2019, far exceed the euro area average.

Thus, I hope the message is clear. Let’s make sure that we do not create bigger problems than the ones we are trying to solve. The sustainable way of truly helping people on low wages is by making work pay and thus eliminate in-work poverty. This means seeing how workers can improve their productivity and skills in order to improve their pay. This also means helping and incentivising businesses to become more efficient in their operations and investing in technology in order to be able to use less human resources but then be able to offer better wages to all.

Ultimately, in the current economic environment, the primary goal should be of moving out of this high inflation as quickly as possible. Any policy decisions, with possible short-term gains, that then prolongs inflation and feeds the inflation monster will erode Malta’s competitiveness. It is misguided to try to push demand to maintain a certain level of economic growth while not tackling the inflation problem.

As the ECB made it clear on multiple occasions, its monetary policy tightening was primarily motivated to attack inflation expectations, as the more everyone keeps expecting that inflation will remain high, the more likely that the inflation problem will persist for longer which ultimately risks bringing about an economic meltdown. Ultimately, we must make sure that fiscal policy does not end up working against the targets of monetary policy. The least we need is for other economies to respond to higher interest rates and manage to bring their inflation under control, while Malta will have to deal with higher inflation for a longer period, resulting in lower economic growth for a longer period and a high public debt to contend with. Ultimately this would result in having Malta’s public debt become unsustainable as we would have lower economic growth for a longer time period.

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