How Often Do Economies Enter Inflationary Spirals?


Inna Biktimirova


2021 and 2022 turned into a true inflationary shock for the world economy. Developed countries have not seen such a spike in prices since the 1980s. At the same time, the situation on the labor market was changing: the economies were recovering after the Covid pandemic, the demand for labor was growing, but supply was falling behind, which contributed to the growth of wages.

Many economists talked about the risk that the dynamics of wages and prices could mutually lead to a spiraling growth of both indicators. The IMF experts decided to check how frequent this phenomenon is (you can read their paper or a column on the CEPR website). 

The inflationary spiral is a theory describing a continuous and accelerating rise in the prices. The reason behind it is the following: an increase in demand leads to an increase in prices; workers, in an effort to avoid a drop in real earnings, demand an increase in nominal wages, which forces firms to further raise prices, after which workers demand an even greater increase in their wages. Central banks need to timely assess the risks of a spiral so that they do not have to clamp down on demand too much later on by raising interest rates and creating recession risks (last year the US Fed steadily raised the key rate from 0-0.25% to 4.25-4.5%). The Russian Central Bank spoke about the risks of an inflationary spiral in the country in the spring of 2022.

How can the inflationary spiral be identified? The IMF experts define a wage-price spiral as an episode where at least three out of four consecutive quarters see accelerating consumer prices and rising nominal wages. They found that the spiral is not a very frequent phenomenon: between 1960 and 2021 (for most countries, data is available only from the 1980s or 1990s), there were only 79 such cases in developed economies.

In most of them, the situation stabilized within eight quarters, and real wages did not get into a spiral (in the US, for the most part in 2022, real wages either decreased or remained unchanged). Only in a minority of the 79 cases, there was a further acceleration of inflation and nominal wages after eight quarters, the IMF economists write. 

"The inflationary spiral can be studied from the point of view of Markov chains (when the new state or event depends only on the previous one – editor) and switching between different states of the world," says Oleg Shibanov, Head of Sber Center for Macroeconomic Research and NES Professor. "For example, a paper by [Ricardo Reis from the London School of Economics] examines how consumers' confidence or inflation expectations change over time. If we believe that inflation expectations remain low after 2022, and confidence in central banks has not fallen too much, then we should expect inflation to decline in the coming years. If we believe that the world has switched to a new state of "high inflation expectations and low confidence in central banks", then we will have to expect problems for many years to come," Shibanov adds.

According to the IMF economists, 2021 data has not revealed serious risks of an inflationary spiral yet, although it is too early to make a final conclusion. They found that the current situation (in particular, a drop in real wages with declining or unchanged unemployment) is similar to 22 episodes in the past. There were no stable inflationary spirals after them, and eventually the situation stabilized. In 2022, annual inflation began to slow down by the year end: in the US – to 6.5% in December after a peak of 9.1% in June, in the eurozone – to 9.2% in December from a record 10.6% in October.

The acceleration of nominal wage growth does not necessarily mean that the spiral of wage-price growth is gaining momentum, the IMF experts conclude, judging from history. The analysis shows that nominal wages can grow faster and faster, while inflation recedes. 

Source: Haver Analytics, International Labour Organization, OECD, IMF


"Following 2022, I have become more optimistic. Inflation in developed countries is gradually stabilizing, including against the background of declining energy prices, and confidence in central banks is quite high. The regulators, in turn, are doing the right thing by raising rates. The Fed's rhetoric about having to endure a recession and higher rates is particularly harsh. Therefore, I do not expect an inflation spiral, though we need to wait until the end of 2023 to make a final verdict," Oleg Shibanov notes.