Sticky inflation

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

Sticky inflation is an undesirable economic situation where there is a combination of stubbornly high inflation, which is often coupled with stagnant economic growth.

What causes sticky inflation? There could be various causes. The first cause is Cost-Push Factors, whereby upward pressure on inflation could come from supply side shocks or constraints leading to higher fuel prices or higher food prices. Another cause is Expectations. Inflation is often sticky and difficult to reduce when people expect higher inflation. When people expect higher inflation, it can be more difficult to reduce it, leading for example for employees to bargain for higher wages in anticipation of inflation. A further cause is wage push inflation, where labour is able to push for higher wages, despite lower economic growth.

So what is causing the present sticky inflation we are experiencing, notwithstanding the rather aggressive monetary policy tightening central banks have employed? I will try to provide some perspectives from leading research articles. On one hand, we are seeing a decline in headline inflation, which to a significant extent rests on the decline in energy inflation and a marked drop in food inflation. However, core inflation is projected to moderate more gradually. Why is this?

The main reason for this is that while energy shock unwinds and supply chains normalise, domestic demand and wage growth has become the dominant factor driving recent inflation developments and is expected to remain so for some years. Demand-side shocks tend to be more persistent, with wage agreements having on average a longer duration than supply shocks.  One needs to have a look at the price pressures in the services sector, where labour costs represent a larger share of total costs, as these are expected to fade more gradually.

One also must look at the structural changes in the economy, which dampen the effects of monetary policy. While in Europe the services sector accounted for around half of gross value added during the monetary policy tightening cycle of the 1970s, it now accounts for more than 70%. This means that in Europe today, three jobs out of four are in the services sector. Because services are less capital-intensive and their prices are, on average, more rigid than in other sectors, changes in interest rates are slower to affect aggregate inflation outcomes.

Another factor effecting inflation stickiness relates to the labour market. One of the greatest benefits of the fiscal and monetary policy response to the pandemic and the war in Ukraine is its impact on the labour market. Employment in the euro area has never been higher and unemployment never been lower, with labour demand remaining exceptionally strong. Surveys point to continued employment growth in the coming months. Studies show that structural factors in Europe’s labour market, that is, a productivity lower than pre-pandemic levels, a higher share of services in value added and a shortage of workers, are contributing to wage inflation. Demand is playing a key role, too.

In the services sector, for example, the share of firms in Europe reporting demand as a factor limiting business remains close to historical lows. Hence, this tight labour market, increases the bargaining power of workers in an environment in which wages are already expanding at a historically high pace. If wages increased by more than currently projected, paired with potentially lower productivity, firms would be more likely to pass on higher labour costs to consumer prices. In such an environment, whether a wage-price spiral will unfold, will ultimately depend on the ability and willingness of firms to absorb higher unit labour costs in their profit margins. This, in turn, depends on the economic environment in which firms operate and hence on monetary policy. Recent work by Ben Bernanke and Olivier Blanchard has examined the role of labour market tightness for the United States. Their work suggests that unless the ratio of vacancies to unemployed workers falls back below its pre-Covid level, inflation is unlikely to return to target in the next three years.

A recent article on the Financial Times, about the elevated price of pasta, was a good case study in inflation stickiness. The bone of contention here is that while the price of wheat has come down substantially, the price of pasta has not. Yet in this article a certain David Ortega, a food economist and associate professor at Michigan State University, explained it perfectly well. He said that food prices tended to be sticky given the range of costs beyond those of their basic ingredients. So, while the price of wheat came down quite substantially, wage costs are still up and some of the raw materials for packaging and others are still high. He gave a case study based explanation as to why we have sticky inflation.

All this should be teaching us a lesson going forward. We should be very careful with blanket compensation adjustment mechanisms that would be akin to a dog chasing its tail. The least we need are measures that keep feeding the inflation beast.

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