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60 second read: Why would higher wages push up inflation?

Paloma Kubiak
Written By:
Paloma Kubiak

Inflation stands at an eyewatering 9% but is expected to reach 11% this year. With strike action taking place as workers call for higher wages, the government warns this will push up inflation.

Here’s a 60 second back-to-basics guide to explain why higher wages would result in even higher inflation…

The theory goes that increasing wages causes there to be an increase in the cost of goods and services.

When a company is required to increase its workers’ pay, then it needs to increase the cost of its products to still make a profit.

This creates a circular effect where higher pay is met with an increase in prices which is then once again met with the need for higher pay to compensate for an increase in prices (an inflation spiral).

This can cause a ratcheting effect and is one of the reasons that the governor of the Bank of England, Andrew Bailey, implored workers to not ask for big pay rises or bonuses because his view was that this would just compound that impact of inflation which already stands at a 40-year high.

However, research suggests that actually it is higher prices that lead to higher wages rather than the other way around.

One of the main reasons that we are seeing inflation at the moment is due to the supply shock caused by the pandemic, which is now exacerbated by the war in Ukraine. Simply, there is not enough supply to meet demand.

Post-pandemic, people’s consumer habits have rapidly returned to normal but production has failed to keep pace. The GDP figure for April fell by a lower-than-expected -0.3%.

This increases the price of goods and subsequently means people want higher wages to cope with these price increases.

However, it is important to prevent an (high) inflationary psyche from becoming entrenched into consumers’ or workers’ mindset – that is, adopting a high inflation mindset and then constantly looking for higher bonuses or higher salaries to cut back on spending.

Paul Craig is portfolio manager at wealth manager Quilter