That anchor for the system came from two sources. First, structural changes to the labor market had weakened the bargaining power of workers in a variety of ways, be it through increased global competition, potential substitutes on domestic markets, or less generous safety nets. The second source was central banks. The real economy understood that if inflation increased, any evidence of second-round effects—on wages—would result in interest-rate rises.
It is those anchors that I think are under threat.
There are now good reasons why the bargaining power of workers may have improved. If, coming out of this shock, participation rates are permanently lower, firms increasingly source labor locally, and households perceive safety nets as more generous, then there is a higher chance that wages respond to higher inflation and demand, despite high unemployment rates.
Added to that, there is a risk that central banks are no longer playing the role of anchor. They are prepared to gamble their inflation “credibility” to exaggerate any economic rebound. Sadly, long-term history is littered with episodes underlining the idea that once inflation credibility is lost, it is hard to regain. What we are learning is that the pandemic shock may have been a temporary hit to demand (though probably not to supply), but its effects aren’t likely to prove temporary on policy. At a time when the market is discussing when the US Federal Reserve and other central banks might raise rates—perhaps at the end of 2022 or early 2023—the fact is that global central banks are still adding liquidity into the system, with another US$1.5 trillion of asset purchases due in the next six months.