Explaining the post-crisis Philips curve: Cumulated wage gap matters for inflation. CEPS Working Document No 2018/05, June 2018

Voinea, Liviu (2018) Explaining the post-crisis Philips curve: Cumulated wage gap matters for inflation. CEPS Working Document No 2018/05, June 2018. [Working Paper]

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Abstract

In this paper we build a new model for understanding the relationship between wage and inflation. We introduce 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 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. We build a theoretical model and then we test it for all OECD countries, for a series of wage adjustments episodes (15 or more years ago, respectively the last global crisis). 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. We find that inflation does not increase close to or above its target level until the cumulated wage gap is closed. In other words, for 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 here is that countries which closed their cumulated wage gap should be much more prudent in further wage increases – because they will be seen in inflation much faster and larger than in the recent past. For countries which have not closed their cumulated wage gap the implication is that inflation will remain subdued until they close their cumulated wage gap.

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