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In the span of 10 days, three major central banks have made policy decisions that appeared to be finely balanced and could have gone either way. Last week, the Federal Reserve unanimously decided to keep its policy rate unchanged but hinted at a potential rate increase in the future. The Bank of England also chose to hold its policy rate steady, but with the votes almost evenly split, there is growing speculation that the peak has been reached. The previous week, despite weakening economic growth, the European Central Bank raised rates.
The increasing uncertainty surrounding the actions of monetary policymakers is not difficult to comprehend. It stems from the deepening uncertainty about what actions they should take. We have entered a time when it is becoming more challenging to interpret signals from both price movements and economic activity. This raises the possibility of errors and a potential divergence among major central banks after more than a year of parallel tightening.
Another reason for potential divergence has been somewhat overlooked. As supply-side factors affecting inflation, such as pandemic disruptions and conflicts over energy and commodity prices, have diminished, the primary risks to prices are now domestic. Central bankers are focusing on wage growth, which, if it remains high, could prevent services and core inflation from aligning with the headline rate.
Wage growth has exhibited different patterns. US hourly earnings have decreased from a peak annual growth rate of 6 percent and have remained in the 4-5 percent range throughout this year. This level is too high to be consistent with 2 percent inflation if sustained. Therefore, the key question for the Federal Reserve is whether wage growth is a reaction to previous inflation, attempting to compensate for real wage erosion. In that case, it may moderate again as headline price growth continues to decline. Alternatively, workers may perceive this rate of nominal wage increases as a new standard that they demand to maintain.
In the eurozone, wages are often determined through collective bargaining rather than market forces. This leads to a delayed response to price inflation, and the European Central Bank’s indicator of negotiated pay growth has risen this year after being subdued. President Christine Lagarde’s remarks on the last rate hike highlighted the centrality of these developments to the ECB’s hawkish stance.
This contrast emphasizes two important factors. First, wage formation and its impact on inflation vary significantly between economies due to differences in labor relations. Therefore, we can expect central banks to behave differently if wages are the driving force. Second, labor markets are inherently political, as demonstrated by the ongoing United Auto Workers strikes in the US. This makes them difficult for central banks to predict and delicate to influence, given that wage negotiations are essentially a power struggle between workers and capital owners. The ECB has clearly acknowledged this dynamic, with its officials often emphasizing the role of businesses’ willingness to let high profit margins absorb temporary wage growth in shaping the inflation outlook.
In all these aspects, the UK stands out as an outlier—unfortunately. Nominal wages in the UK are rising much faster than in the two larger economies. Year-on-year growth in regular pay has now reached 7.8 percent, well above the inflation rate. When the Bank of England has publicly commented on wages, it has sometimes appeared to take the side of capital, sounding like a class warrior. With tensions high in UK labor markets, effective communication is crucial to prevent further exacerbation of labor conflicts. Regardless of the specific wage dynamics in each country, all central banks need to ensure that wage growth aligns with their inflation targets.
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