Wage rigidity to low unemployment: an aberration? Not really.

Central bankers and economists seem baffled by the fact that wages are failing to accelerate in economies where low unemployment is pointing to full employment, which traditionally means rising pressure on wages. In response, central banks are on the alert, fearing that this apparent anomaly will correct itself any time, possibly resulting in a sudden acceleration in pay for which they might be unprepared. In Germany, the unemployment rate is at a post-reunification low of 5.7% and the Bundesbank has been watching this risk closely for almost two years.

However, there has been no trace of inflation, and growth in labour costs has on the contrary slowed significantly in the last few quarters. In the UK, annual wage inflation has ground to a halt in the last few months, despite the unemployment rate also being close to a record low at 4.7%. But it is in the USA that the anomaly is bothering observers the most. US unemployment now equals only 4.3% of the labour force, the lowest figure since 2001 when wage growth was over 4% per year, as it has always been when the unemployment rate has fallen to such low levels.

The Phillips curve showing wage growth moving inversely to the unemployment rate has in the past worked very well in the USA, where pay is more flexible than in Europe. So how do we explain the apparent breakdown in this relationship, and can we really call it an anomaly? After analysing the situation, our answer is no. There are many rational explanations why wages, and therefore inflation, are failing to rise. As a result, central banks should be very careful about wanting to revert to their usual practice of tightening monetary policy when the unemployment rate approaches a level that supposedly denotes full employment.

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