Last Updated on Thursday, 3 August, 2023 at 1:48 pm by Andre Camilleri
Alexander Demarco is Deputy Governor at the Central Bank of Malta
The rise in inflation during 2022 triggered a weekly cost of living adjustment of €9.90 for workers. Although inflation has been on a gradual downward path since it peaked at around October 2022, it nevertheless remains high. Indeed, the Malta Employers Association (MEA) recently indicated that for 2024 it is anticipating that the weekly COLA for workers could amount to around €13.
This may raise concerns of risks of second round effects on inflation, that could trigger a wage-price spiral. What is the likelihood of this happening? The answer hinges on several factors at play, but ultimately boils down to demand and supply conditions and market power in product and labour markets.
The end of the COVID 19 pandemic brought with it a strong rebound in demand, especially in high contact service sectors. An expansionary fiscal policy also buoyed demand. This, together with some element of market power, enabled producers, importers, and retailers not only to pass higher costs arising from terms of trade shocks onto consumers, but also to raise profit mark-ups. Malta has been no exception to elements of profiteering/”greedflation”, as indicated in the Table, using National Accounts data.
While the COLA mechanism insulates the lowest wage earners from inflation, for most workers this wage indexation mechanism is partial. Therefore, in the presence of high inflation, higher wage claims are to be expected to recover purchasing power. The tightness of the labour market only makes the likelihood of wage growth even stronger.
The key question is what wage increases can employers afford to pay without necessitating further price increases? The reply to such question varies across sectors and individual firms. Those that have been able to maintain or even raise their profit margins are in a better position to give higher wage increases without the need of raising further prices compared to those that were not able to do so.
National Accounts data shows that most sectors run by private operators have raised their profit mark-up to a level higher than the pre-pandemic period, with just a few exceptions, namely construction, information and communication, and administrative and support services sectors (NACE F, J and N), as shown in the Table. Aggregating all the sectors that are dominated by the private sector that raised profit mark-ups and those three that didn’t and redistributing part of the increase in profits to wages while maintaining mark-ups at the 2019 level would translate into an average increase in wages of around 4.1%.
This indicates that with a 4.1% increase in wages (inclusive of COLA) in the private sector, profit mark-ups would return to the pre-pandemic period (2019) and therefore increasing output prices in response to such wage increase would be neither necessary nor justified. Indeed, such a wage increase, accompanied by an unchanged profit mark-up, would still imply that the burden of the terms of trade shock would have been fully passed on to consumers.
Average wage increases higher than 4.1% would imply a reduction in the 2019 average profit mark-up. If wages were to increase by 6.2% to fully compensate for RPI inflation in 2022, the profit mark-up for that year would drop from an average of 18% to 16.8%, which would be lower than the 2018-2019 average of 17.5%. In this case, the burden of the terms of trade shock would fall entirely on businesses. These calculations suggest that wage increases (inclusive of COLA) ranging between 4.1% and 6.2% would result in a fairer shared distribution of welfare losses arising from terms of trade shocks between both workers and businesses without the need for a further rise in output prices.
A wage-price spiral could be therefore averted if wage increases do not go beyond this estimated range. Wage growth higher than the indicated range would only be justified if accompanied by higher productivity. At the same time, businesses should refrain from seeking to maintain existing higher profit mark-ups or raise them further through price increases as this would only, justifiably, trigger further higher wage claims. Improved profit mark-ups would be only legitimate with higher efficiency in the production and distribution chain, usually arising from investment in productive enhancing technology and training to upskill the workforce. Profiteering/”greedflation” may appear to make business sense in the short term, but since it undermines competitiveness in the medium term, it would ultimately hurt businesses too.