Since the end of 2021, inflation has surged in developed countries to levels unseen for two decades or more. Inflation hurts most people. Depending on the country, employees have seen their purchasing power decline by some 5% to 15% in a short time. It would seem obvious that their earnings must be adjusted proportionately and quickly. Experience shows that this will happen, eventually. The question is: when should it happen? 

From a fairness point of view, the answer is that it should be done right away. Yet, an immediate and proportional increase raises the production cost of firms, which will need to raise their prices. If wages follow suit, an inflation spiral will ensue with no end in sight. As everyone tries to raise prices and wages faster than others, inflation can continue rising. Inflation becomes a very divisive issue, with the weaker people invariably finding themselves on the losing side.

This is why it is imperative to stop inflation as early as possible. This is the task of central banks, because they alone have an effective, albeit painful, tool. By discouraging employees and firms from playing the “price hike” game, banks can then raise interest rates, which reduces spending, hence leading firms to moderate price increases. As sales weaken, firms cut into their hiring plans or fire employees. Rising unemployment, in turn, discourages wage increases. But between a recession and high unemployment, everyone loses.

Is there a less painful way to stunt the inflation spiral? Price and wage have been tried all over the world for decades but the record is highly disappointing. Controls initially work, but when they are released, inflation comes back with a vengeance as firms and employees seek to make up for their losses. If the controls last, they are gradually circumvented, as black markets arise in response to scarcity. Another popular temptation is to make inflation painless by indexing prices and wages. The result, known as inertial inflation, is the surest route to ever-rising price increases. When traditional monetary policy is finally used, it must be even tougher. 

Probably, the least painful approach is to combine standard monetary policy with voluntary wage moderation. Limiting wage increases early on may blunt the inflation spiral before it takes a life on its own. For the employees, it obviously means losses in purchasing power. They must be reassured that, once inflation subsides, wages will be progressively raised to fully catch up with prices. An additional temporary compensation for purchasing power losses accumulated in the interim period is not just fair but also stands to obtain an agreement in the first place. Wage moderation may seem like wishful thinking but it has been happening to some degree in many countries. 

This article was published in Globe #31, the Institute Review.