Semin Soher Power: Wage hikes are the one to watch if inflation takes off again

Eurozone inflation is predicted to be considerably above the ECB’s 2% inflation target and the risks are on the upside as uncertainties remain

ECB president Christine Lagarde believes that society has learned how to cope with the pandemic and most central banks are now announcing the end of their easing policies.

The focus of markets shifted during the year from worrying about Covid to the next major risk: Inflation. 

As growth recovered and interest rates remained low, equity valuations, house prices, Bitcoin, commodities, and other asset prices all rebounded. 

Whether such trends continue will be up to how inflation behaves and how central banks respond to it. 

Supply chains, semiconductors, and congestion at ports have never been as topical as they were this year. As car production was delayed, used car prices spiked globally.

In all, consumer demand shifted from the hoarding of toilet paper and pasta to buying new phones, game consoles, furniture, and a whole range of goods. 

Suppliers of goods were caught out: Some shipping companies had sent their ships to scrapyards and factories had scaled back production. 

What was different this time was that large-scale fiscal stimulus and unemployment benefits and business supports, as well as interest rate cuts, helped trigger a very fast recovery. 

Covid variants Delta and Omicron are, however, delaying a full recovery even as the pace of vaccinations and boosters picks up. 

ECB president Christine Lagarde believes that society has learned how to cope with the pandemic and most central banks are now announcing the end of their easing policies. 

In the US, the Federal Reserve announced that their asset purchase programme will end in March, and that three interest rate hikes are likely there in 2022; the Bank of England has already delivered its first rate hike. 

The eurozone economy is expected to grow significantly and pre-pandemic levels of GDP will soon be reached. 

The labour market is also healing with lower unemployment rates and smaller number of people on government supports.

Eurozone inflation, however, is predicted to be considerably above the ECB’s 2% inflation target and the risks are on the upside as uncertainties remain.

One key area to watch in the year ahead is wages. 

As the cost of living increases due to higher energy prices, higher utility costs, higher food prices, and supply chain issues, incomes have to pick up too so that household purchasing power doesn’t get eroded. 

A large number of strikes in the US in 2021 saw October earn the nickname of "Striketober" on social media. 

For the first time since the 1970s, we are hearing about Cola, or cost of living adjustments, linking wages directly to consumer price inflation in the US. 

This time employers are looking to keep staff and attract new workers.

So far in Europe, wage negotiations have had muted results, but the overall European economy is lagging behind the US in its economic recovery and higher wages are also likely in Europe too. 

But this is a major risk for central banks; inflation targeting is the basis of current central bank policy. 

With the ECB projecting 2.6% inflation in 2021, a rate of 3.2% in 2022, and 1.8% in 2023 and 2024, the ECB's Pierre Wunsch, the Belgium central bank governor, now believes the ECB has already achieved its inflation target. 

With the EU's Next Generation package supporting growth, the feeling is that the ECB doesn’t have to do any more heavy lifting. 

Financial markets nonetheless are not expecting the first ECB rate hike until 2023.

With the Bank of England and multiple central banks in emerging market economies already delivering rate hikes, and with the Federal Reserve starting its rate hiking cycle in 2022, and the ECB possibly following in 2023, excess liquidity will decline sharply and the cost of borrowing will increase significantly, providing challenges for businesses. 

Global bond markets currently see a very uncertain outlook and are already pricing in rate cuts to follow rate hikes as the levels of debt and leverage are still very high.

The million-dollar question is how successful and productive the 'green transition' and other large-scale fiscal spending programmes will be. 

If the new infrastructure investments, the clean energy transition, and enhanced digitalisation can improve lives significantly and help increase productivity and spark long-term growth, financial markets will regain their confidence. 

Until then, we could see an increase in volatility in the coming months as 2022 progresses.

• Semin Soher Power is head of inflation trading at Bank of Ireland Global Markets