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Analysis

Filling the Phillips gap

Implications for monetary policy

by Gary Smith in London

Wed 2 Aug 2017

Inflation continues to undershoot market forecasts and central bank targets. This is a matter of concern. The global economic recovery is one of the longest on record. Unemployment has fallen in many countries but, contrary to economists’ expectations, this has not led to wage inflation.

The lack of wage inflation may impede interest rate normalisation in coming quarters, which may in turn have important implications for policy manoeuvrability when the next recession hits. ‘Lower for longer’ might become ‘lower forever’, providing further impetus for investors to seek asset-class diversification as they hunt for yield.

The inverse relationship between unemployment and inflation, identified by the Phillips curve, has changed. This has surprised economic forecasters. However, much has altered since William Phillips published his seminal paper establishing the relationship in 1958.

Increased life expectancy and better health are enabling and encouraging older workers to stay in the labour market for longer. This helps them to keep occupied and to deal with the financial implications of longevity.

Older workers are motivated in part because low interest rates are leading to disappointing capital market returns, reducing their income from savings. Many people, especially those in defined contribution schemes, have retired with lower pensions than they expected.

As a result, workers delay retirement to help compensate for the impact of low interest rates. However, by doing so, they tweak the lifetime savings and spending balance, and place further downward pressure on interest rates. The question arises as to whether this pressure to work for longer will ever be alleviated.

The most aggressive wage demands typically emanate from young workers. But in the US the share of such workers in the labour market is falling, according to Deutsche Bank. Older workers are less aggressive wage negotiators because they are less likely to change jobs (and changing jobs is a common way to get a wage rise).

In many countries union membership has fallen. Andy Haldane, chief economist of the Bank of England, identified that around 6m employees in the UK are members of trade unions compared with 13m in the late 1970s. Collective wage negotiations are less common and individual agreements have become more widespread. This has helped dampen wage inflation.

This shift towards individual wage negotiations reflects changes in the labour market, in particular the increase in self-employment and part-time working. Economists are still grappling to understand all the consequences, and the Bank of England has commissioned a review that will report later this year.

One consequence that is evident is that the growth of the gig economy, characterised by the prevalence of short-term contracts and freelance work, has created uncertainty for many workers. This has further reduced the incentives for wage negotiation, putting downward pressure on wage inflation.

The data suggest that workers tend to prefer to be self-employed as they get older. This means that as the share of older workers in the labour market increases, the number of self-employed workers is also likely to rise. They are a key component of the ‘marginal worker’ count, often viewed as critical in determining the outcome of wage negotiations.

Finally, there is the role of technology and globalisation, which may have weakened the bargaining power of workers and led to a decline in the labour share of profits.

Given that there are so many reasons for weak wage inflation that would have been unknown to Phillips in 1958, it is probably not surprising that his explanation of the trade-off between unemployment and inflation appears to have broken down.

Gary Smith is a Member of the Strategic Relationship Management Team at Barings and a Member of OMFIF's Advisory Council.

 

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