15 Jun 2018

Explaining the post-crisis Philips curve

Cumulated wage gap matters for inflation

Liviu Voinea

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This paper constructs a new model for understanding the relationship between wage and inflation. It introduces the concept of a cumulated wage gap – meaning the cumulated gap between the current wage and a maximum reference wage value in the past. The permanent income hypothesis is fundamentally flawed in times of crisis, because of the uncertainty of future income. In a crisis, the reference is not expected income, but rather past income. Retirement savings and linear employment prospects are uncertain. People relate to their peak gains in the not-so-distant past rather than to uncertain future gains. The only certain reference value lies in the past, not in the future: and that is why current consumption is influenced by past income.

The post-crisis Philips curve uses the cumulated wage gap instead of nominal wage. This is a measure of stock, not of flow. The post-crisis Philips curve is non-stationary, as it moves over time.

The author builds a theoretical model and then tests it for all OECD countries, for a series of wage adjustments episodes (15 years ago or more). The model is empirically validated for all countries – including, to varying degrees, US, UK and euro-area, as the cumulated wage gap has a strong explanatory power on the deviation of inflation from its target.

The analysis finds that inflation does not increase close to or above its target level until the cumulated wage gap is closed. In other words, for the Philips curve to work, the loss of welfare from a negative cumulated wage gap must be fully compensated first – as a stock measure, not as a flow.

The policy implication from this finding is that countries that closed their cumulated wage gap should be much more prudent in making further wage increases, because they will be seen, with inflation, to be much faster and larger than in the recent past. For countries that have not closed their cumulated wage gap, the implication is that inflation will remain subdued until they close their cumulated wage gap.

Liviu Voinea is Deputy Governor of the National Bank of Romania.