A wage-price spiral cannot start in Portugal today

  • Álvaro Almeida
  • 4 May 2022

One of the lessons that has been frequently mentioned in recent weeks is the danger of a “wage-price spiral", a phenomenon that in the 1970s and 1980s caused increasingly accelerating inflation.

Consumer price inflation in Portugal reached 5.3% in March 2022. This is the highest level in 28 years, leading many to go back to the past searching for policy lessons. One of the lessons that has been frequently mentioned in recent weeks is the danger of a “wage-price spiral”, a phenomenon that in the 1970s and 1980s caused increasingly accelerating inflation in many countries, and had damaging consequences, especially to nominal-income earners, like pensioners and holders of fixed-income assets.

The wage-price spiral is an economic term that describes the phenomenon of price increases as a result of higher wages, and vice-versa. Faced with an inflation surprise, workers demand wage increases to maintain real wages constant. Higher wages increase the costs of production, and firms must increase prices further to maintain profits. This additional price increase leads workers to demand further wage increases, that will force firms to increase prices even further, in a continuous loop. This wage increase-price increase spiral generates increasingly accelerating inflation and will lead to hyperinflation if the spiral is not broken by adequate policies.

“Inflation is always and everywhere a monetary phenomenon”, Milton Friedman once said, referring to the fact that in the long run inflation is constrained by monetary policy. That is the main reason why most central banks now have an inflation mandate, since central banks are the institutions with the tools to control inflation. When central banks effectively target inflation, they will apply a contractionary monetary policy (higher interest rates) if a wage-price spiral starts, implying that any spiral will be temporary and cannot generate ever increasing inflation. Nevertheless, wage-price spirals can be harmful even in those settings, since a stronger spiral will require stronger policy measures to control it, in the form of higher interest rates that could cause a deeper recession in the economy. Wage-price spirals cause serious economic harm and were a major problem in Portugal in the 1970s and 1980s. But the structural changes that occurred since made a wage-price spiral in Portugal simply not possible today, and even if a spiral did start it would not have any meaningful consequences, due to three factors.

First, Portugal is a now member of the Euro area, and thus the monetary policy that determines inflation in Portugal in the long run is set by the European Central Bank (ECB). The primary objective of the ECB’s monetary policy is to maintain inflation in the Euro area at 2%, measured by the annual increase in the Euro area Harmonized Index of Consumer Prices (HICP). As long as the ECB fulfils its mandate, inflation in Portugal will only increase above 2% temporarily. There is a clear anchor for inflation expectations in Portugal that leads workers to accept more moderate wage increases knowing that inflation will converge to 2% in the long run.

In the 1970s, Portugal had its own currency (Escudo) and thus its own monetary policy run by Banco de Portugal (BdP). There was no inflation target and the nominal anchor of the 1960s (a fixed exchange rate) had been effectively abandoned. In practice, the main objective of monetary policy was to finance the government budget deficit, not to control inflation. This meant that there was no clear anchor for inflation expectations in Portugal: when agents observed an increase in inflation, they had no reason to expect that inflation would not continue to increase in the foreseeable future. Then, if a wage-price spiral started, workers would demand wage increases higher than current inflation, since they were expecting (and causing) inflation to accelerate further.

Second, in the 1970s firms in Portugal were able to increase prices without losing competitiveness, because the BdP allowed the escudo to devalue, and firms could maintain their prices in US dollars or German marks, even with higher prices in Escudos. Trade restrictions and border controls also helped to limit the effects of international competition on Portuguese firms, especially for services and agricultural goods. Today, Portugal is in the European Union, an area of free trade in goods, services and capital, and competition limits the ability of Portuguese firms to increase prices. International competition prevents firms from accepting excessive wage increase demands, and if wages eventually increase, firms will not increase prices.

Third, inflation in Portugal represents 2.3% of Euro area HICP, implying that a 1 percentage point increase in the rate of inflation in Portugal increases the Euro area HIPC by only 0.02 percentage points. In other words, the inflation rate in Portugal is practically irrelevant to the indicator that the ECB targets, and thus it is irrelevant to the ECB’s monetary policy decisions. This implies that any increase in inflation caused by an increase in wages in Portugal would not affect the ECB’s monetary policy and thus would not lead to higher interest rates in Portugal.

In conclusion, no wage increase in Portugal could start a wage-price spiral, and certainly not an increase of public sector wages. Higher wage costs for the public sector do not imply higher “prices” for public sector services. Even if there were “imitation effects” that lead private sector workers to demand higher wages (and there is no compelling reason to expect such effects), international competition will limit the ability of firms to accept those demands, and limit even more their ability to increase prices. Finally, there is no risk that the wage increase would cause a recession through an increase in interest rates. However, a recession is likely if wages do not increase in line with inflation, because the decrease in real wages will decrease private consumption.

  • Álvaro Almeida
  • Associate Professor at University of Porto, Faculty of Economics