How are wage developments passed through to prices in the euro area? Evidence from a BVAR model

ABSTRACT

This paper explores the transmission mechanism between wages and prices in the euro area. While labour costs account for notable parts of companies’ costs and should, hence, be of relevance for the developments in inflation, the empirical literature suggests only a loose link between the variables. From a theoretical perspective there are at least two broad categories of channels of how labour costs and prices can be linked, namely the supply-side channel of cost push inflation and the demand-side channel of demand pull inflation. This paper develops a BVAR model for the wage-price pass-through in the euro area and analyses how supply and demand shocks that trigger these two types of inflation are transmitted between wages and prices along the cost side of the economy. The main results can be summarized as follows: First, the wage-price pass-through in the euro area is shock-dependent. Second, the pass-through of wages to prices appears to have undergone some changes over time. Third, the pass-through appears to differ across HICP components. Finally, historical decompositions show that the identified shocks are of relevance for the movements of wages and prices in the euro area.

KEYWORDS:

• Euro area inflation
• pass-through of labour costs
• BVAR
• time-variation

JEL CLASSIFICATION:

• C32
• E31
• J30

Acknowledgments

The views expressed in this paper are those of the author and do not necessarily reflect those of the European Central Bank. I thank Thomas Westermann and an anonymous referee as well as participants at internal presentations at the ECB and at presentations at the 25th International Conference on Computing in Economics and Finance and the International Conference on Economic Modelling and Data Science 2019 for valuable comments.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

¹ The empirical analysis was conducted with the BEAR toolbox. See Dieppe, Legrand, and van Roye (2018).

² Note that including the price variables individually in the model led to virtually unchanged results.

³ Energy prices play also no dominant role in the GDP deflator. This is the case as the euro area is an oil importing economy and oil import prices, which are subject to a high degree of volatility, are not part of the GDP deflator. Only the prices of energy that is produced in the euro area are included in the GDP deflator. It includes for instance electricity prices which evolve, however, in a more stable way than oil prices.

⁴ Note that the same patterns of responses are found if real wages are included in the model and the restrictions are put on real instead of nominal wages.

⁵ Note that while employment is not a variable in the BVAR, as real GDP and labour productivity are included in the BVAR, the impulse response of employment can be derived as well and shows a decrease in the case of an adverse labour market supply shock.

⁶ Again the impulse response of employment is derived from those of real GDP and labour productivity. It shows an increase in employment in the case of a positive demand shock.