"Ination and labour market dynamics after the pandemic" - Sharon
Donnery at 10th Annual Donal Nevin Lecture
10 November 2022 Speech
10th Annual NERI Dónal Nevin Lecture delivered by Sharon Donnery, Deputy Governor, Central Bank
of Ireland and Member of the Supervisory Board of the ECB, 10 November 2022
Introduction
Good morning everyone. Thank you for that introduction. Thank you also to colleagues at the Nevin Economic Research
Institute for inviting me here today. It is a pleasure to give the Donal Nevin lecture this year and I very much look
forward to hearing Kevin's [Callinan] response to my talk, and participating in the discussion.
My aim here today is to give you a perspective on what is driving the high levels of ination we are currently
experiencing, how labour market developments might inuence the ination outlook, and nally what all of this means
for monetary policy.
The topics of ination and labour market dynamics need little justication in the current context, or indeed to this
audience, but I believe that they are also very tting topics for a Donal Nevin lecture.
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Both issues were never far from the economic policy discussions that Donal Nevin was involved in over his long career.
As a founding member and former president of the ESRI, and having served with distinction in the Department of
Industry and Commerce and as general secretary of the Irish Congress of Trade Unions before he retired in 1989, Mr
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Nevin was known as a man of great intellect and integrity , who had devoted his life to public service. In preparing for
this lecture, I had a look at some of his contributions to the policy debates of the 1970s and 80s, and it is clear that the
challenges and trade-offs that arise from trying to promote sustainable employment growth and better living standards
without also fuelling ination was familiar territory.
Of course, the topics might be familiar, but we should also be cautious about drawing too many historical parallels.
Today we operate in very different economic environment to the one that confronted Donal Nevin during much of his
career. From my own perspective, and given the issues I will discuss today, the fundamental changes in the institutional
setup for monetary policy are one obvious difference. The Central Bank of Ireland is now one of nineteen national
central banks in the Eurosystem, with price stability as the ECB's primary objective. And, as Monetary Policy is set for
the euro area as whole, in my speech today I will emphasise both Irish and euro area developments.
Later, I will talk more about what exactly price stability means, but essentially it is about preserving the purchasing
power of the euro by ensuring low, stable and predictable prices for the euro area as whole. As we all know, ination
during 2022 has been anything but low, stable or predictable. I will talk a good deal about ination - what the key drivers
are and what to expect going forward.
In the second part of the lecture, I will delve more into labour market developments, and what they mean for both
ination and wages.
Ination and labour markets are, of course, linked through a variety of channels, such as labour market tightness in a
Phillips curve framework. Expectations is another potential channel. Persistently high ination can cause ination
expectations to drift upward and become entrenched in wage demands, making it even more challenging to hit our
ination target.
In both the euro area and Ireland, employment is up sharply on pre-pandemic levels and unemployment rates are close
to all-time lows. And, despite a highly uncertain growth outlook, the number of job openings has remained high and
large numbers of rms report labour shortages. How the labour market responds to the weakening growth outlook
remains to be seen, but our current projections are that a tight labour market and real wage catch-up for the current
bout of ination will support strong nominal earnings growth of around 5-6% in Ireland in both 2023 and 2024, and 4-
5% in the euro zone. For the euro area at least, this level of wage growth is well above historical averages, and one of
the reasons underlying (or 'core') ination is expected to remain elevated in the near term, before returning towards 2%
by 2024. However, it is worth pointing out that forecasting in such a volatile and uncertain world is very challenging.
Ination expectations also inuence wage and price dynamics. If higher ination is expected to persist, then workers will
naturally demand higher wages, and employers may in turn raise their own prices. This staggered adjustment of nominal
wages and prices to preserve real wages and mark-ups - the so-called 'wage price spiral' - was a feature of
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macroeconomic and ination dynamics during the 1960s and 70s.
Pre-empting some of what follows, my own view is that there is little evidence of any such self-reinforcing wage-price
dynamics at the moment, either in Ireland or in the rest of the euro area. This does not mean we do not expect nominal
wages to adjust to the large price changes we have seen - and our research shows this is happening across the euro
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zone, albeit at a lag and not fully. Current projections include allowances for real wage catch-up, and this expected
adjustment of real income also feeds into our growth forecasts. Rather, what I do not see in the current data is
signicant evidence of a shift in medium-term ination expectations signicantly above our 2% target. If this were to
happen, it could prompt the sort of self-reinforcing wage-price dynamics, with third and fourth round effects into wages
and prices that proved so painful to unpick in the past.
There is, however, no room for complacency. In spite of rising rates and a weakening outlook, labour markets remain
tight, and ination expectations have moved up alongside headline ination. This momentum, combined with higher
ination expectations in the tail of the distribution, indicate a greater risk of medium-term ination expectations moving
away from our 2% target. Were expectations to become 'dis-anchored' in this way, it would jeopardise the ECB's ability
to sustainably achieve its medium-term ination target. Preventing this from happening - getting ahead, if you like, of
any potential shift in expectations - is just one of the reasons the ECB has started to raise policy rates ( ECB, July 2022 ).
The nal part of the lecture, where I consider the policy choices, will revisit ination expectations. But rst, a remainder
on how we ended up with the high ination we are currently experiencing. After that, I will discuss labour market
developments, focusing on measures of labour market tightness and what this could mean for future wage growth.
Ination
To begin with, some institutional background, which provides context for the policy discussion later.
As a euro member, the Central Bank of Ireland is one of nineteen national central banks in the Eurosystem. Along with
the other national governors and the ECB's six executive board members, the Governor is a member of the ECB's
Governing Council. It meets every six weeks or so to decide monetary policy in order to achieve the ECB's primary price
stability objective for the euro zone as whole. This euro zone perspective means that policy takes account of
macroeconomic developments for the entire euro area. Being a member of the euro has obvious benets, such as the
promotion of trade and investment both within and outside of the bloc. But a single monetary policy means also means
that at times, a given monetary stance may not be fully aligned to the economic conditions in every country. In these
situations, other policy levers - such as domestic scal policy, and national macro-prudential policy - become even more
important for ensuring domestic economic and nancial stability.
In 2021, following a wide-ranging monetary policy strategy review, the Governing Council reafrmed that price stability
is best maintained by aiming for 2% ination over the medium term. The medium term horizon is important for two
reasons. First, it allows for exibility in responding to economic shocks, and also to take account of uncertainties in both
the ination process and the transmission of policy. Second, it allows for the possibility of temporary shocks dissipating
of their own accord, without policy inducing unnecessary volatility in output and employment.
This approach of 'looking through' temporary supply shocks has been severely tested in the last 18 months. It could be
argued - with the distinct benet of hindsight, of course - that repeated supply shocks have combined to produce a
persistent supply shock that has effectively reduced output below its pre-pandemic potential for much longer than rst
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anticipated. When combined with the strong demand rebound - in part due to the pandemic policies that largely
preserved household income - the conditions were set for the sort of persistent and broad-based ination we are now
experiencing. Of course, the persistent, overlapping and unprecedented scale of the supply shocks were clearly not the
sort of shocks we had in mind when we talked about the medium-term horizon in the strategy. Who, for example, would
have predicted the pandemic or even a war in Europe in 2022? What is clear is that once the nature of the supply shock
became clear, and conditional on the strong demand we saw coming out of the pandemic, there is a role for monetary
policy to react in order to bring supply and demand back into balance and sustainably return ination to target.
Commitment to the 2% ination target is symmetric, which means that both negative and positive deviations are equally
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undesirable. However, the problem we currently have is clearly not too low ination. Headline ination in October was
9.6% in the Ireland and 10.7% in the euro area (Chart 1). Contrast this with the ten years to December 2019, when
ination increased at an annual average rate of around 0.5% - and by 1.3% in the euro area.
How did we get to here?
These current high rates of ination are the result of a series of overlapping shocks that have hit the global economy
over the last two and half years, beginning with the onset of the pandemic in the spring of 2020.
Economy-wide shutdowns disrupted production and distribution, leading to widespread supply bottlenecks. Before the
start of the war in Ukraine, researchers estimated that around half of euro area ination and one-third of US ination in
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2021 was driven by these supply shocks. Some of the reduction in supply was itself a response to the initial pandemic
demand shock, as in the case of energy during 2021. Transport bottlenecks also hit supply, with delivery times reaching
more than double pre-pandemic levels - although this has eased somewhat during 2022. Whilst there were country-
specic dimensions to restrictions and associated disruptions - China's 'zero Covid' policy being one example - inter-
connected global supply chains meant that the ripples from supply bottlenecks were global, and slow to unwind.
A second shock or change which matters for ination is pandemic-related shifts in the composition of demand. The initial
shift was away from services - where spending opportunities were restricted because of lockdowns - towards goods.
The change in the composition of spending was particularly large in some countries, such as the US. Central Bank
tracking of Irish consumer spending using high frequency card spending data showed similar changes during 2020 and
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2021, with a strong rebound in services spending in 2022 as the nal set of restrictions were lifted.
A feature of the post-pandemic recovery was a surge in demand that occurred across many major global economies at
more or less the same time. Strong demand, which also spilled over geographically, only served to put further pressure
on already stretched global supply chains. Goods ination - which accounts for a quarter of the consumer spending
basket - is currently far above historical averages, at 5% in Ireland and 5.5% in the euro area. For Ireland, where goods
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deation put downward pressure on overall (HICP) ination for much of the last two decades, this is a huge swing.
The third shock is Russia's war of aggression against the Ukraine, which, quite apart from the devastating consequences
for the people of Ukraine, has also exacerbated global inationary pressures and supply-side constraints, notably in
energy and food commodity inputs.
The euro area is net importer of energy. Therefore, the scale of the energy price changes we are facing - up around 40%
in the last year- constitute an unprecedented terms of trade shock for the euro area. We are all signicantly worse off as
a result. Some groups in society are more affected, especially those for whom energy and food account for a greater
share of spending. We know that lower income and older households are particularly vulnerable, something I return to
in the policy discussion below.
The components of current ination in Ireland and the euro area
Given the common nature of the shocks that are driving ination, as well as the global inter-connectedness of many
inputs and outputs, it is unsurprising that Irish ination moved broadly in-line with the euro area average in recent
months.
This was not always the case, such as during previous inationary (early 2000s) and deationary domestically-driven
episodes (after the nancial crisis).
Some euro area countries are currently experiencing relatively higher rates of ination, notably Baltic countries, where
import trade links with Russia were stronger before the war, including for energy.
Despite accounting for around a tenth of the consumer spending basket, almost half of euro area headline ination in
2022 is directly due to energy. However, as energy is an input in the production of other goods and services, energy
price shocks also indirectly impact non-energy ination rates as costs rise. These energy cost-push linkages are
strongest for food production, a wide range of energy-intensive manufactured goods, and transport services.
Commodity price increases are also contributing to higher food prices. Global supply bottlenecks and the indirect effect
of higher energy prices had already contributed to higher food commodity prices before the war in Ukraine. However,
following the invasion, and reecting the Russia and Ukraine's role as a major supplier raw food inputs, commodity and
producer prices spiked again. These pipeline price pressures are still trickling through the food supply chain. Our own
internal estimates suggests that the pass-through of commodity price changes peak at between 6 and 12 months, but
continue to inuence consumer price developments up to 24 months later. Looking ahead, commodity futures prices
have since come down more recently, reecting both substitution and the reopening of some supply routes.
High ination is a broad-based phenomenon. As of July, more than 80% of the items in the Irish HICP basket were
increasing by more than 2%, with similar gures for the euro area. This share is up from around 20% of items pre-
pandemic. This broadening of ination is driving up 'core' ination - that is, HICP ination excluding energy and food -
which was 4.8% in the euro area and 5.1% in Ireland in September.
I emphasise core ination trends because, for monetary policy makers, it is an important metric, for a couple of reasons.
First, as headline ination can be volatile, and, historically at least, the most volatile components tend to be the least
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persistent, policy makers pay close attention to measures of underlying ination, such as core ination. Underlying
measures indicate where headline ination could settle after short-term factors fade, which is relevant for the medium-
term orientation of monetary policy I mentioned before. For the euro area, private sector forecasters expect core
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ination to average around 4.0% in both 2022 and 2023, before falling back to 2.6% in 2024. The ECB's own
projections from September 2022 show core ination at 2.3% in 2024. Although, this still includes some residual
second-round energy effects working their way through prices. These projections will be updated for the December
Governing Council meeting, when National Central Banks own forecasts will be amalgamated to complete the euro area
picture.
The second reason we care about core ination is because historically it has tended to move closely with wages. In
assessing potential cost-push ination drivers, wage developments are an important consideration, particularly wage
growth that is over and above labour productivity growth. Of course, a wide range of other non-wage costs are also
relevant, as recent developments have shown. And let me be clear, wage pressures are not the primary driver of the
current bout of high ination. But what we clearly want to avoid is a situation where, once the current supply shocks
abate, domestic wage pressures are a factor contributing to ination remaining above our target over the medium term.
This is a timely point to move on to labour market developments.
Labour market and the outlook for wages
The outbreak of the pandemic ended one of the longest continuous employment expansions on record: between 2013
and 2020, employment grew in all but a handful of quarters. Net inward migration was a key driver of these trends:
between 2015 and 2019 net migration - many of whom were of working age - totalled some 110 thousand people, a
large number in the context of an increase in overall employment of 263 thousand over the same period.
In 2018, employment returned to pre-nancial crisis levels, albeit with a very different composition. Notably, a much
lower concentration in construction. By the end of 2019, wage growth was beginning to pick up and concerns over the
risk of 'overheating dynamics' were emerging in the context of a tightening labour market and strong domestic
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demand.
I will not dwell on the labour market impact of the pandemic itself. This is not to minimise how large a negative shock it
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was, and how badly certain groups in society were affected. Nor to gloss over some of the policy innovations which
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evolved rapidly to deal with the shock. Rather, I want to take a more forward-looking perspective, beginning with the
rebound from the pandemic, how this has led to tight labour market, and what this might mean for wages.
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... a strong rebound, drawing in labour supply from outside the labour force
The rollout of vaccines and the gradual withdrawal of restrictions saw total employment surpass its pre-pandemic trend
by the end of 2021.
The latest labour force survey for Q2 2022 puts employment at 2.55 million, almost a quarter of million above pre-
pandemic levels. Although, as average hours tended to be lower, at least in the initial phase of the recovery, total hours
worked is only now approaching its pre-pandemic trend.
Reecting in part lingering pandemic effects on both the demand and supply side, the recovery has been uneven across
sectors.
Total hours worked in contact intensive jobs in the Accommodation and Food and Other Services remain below their pre-
pandemic levels. Overall, however, weaker employment growth in a handful of sectors has been more than offset for by
signicantly stronger growth in a number of other sectors - notably IT (+32%), education (+17%), professional services
(+13%), construction (+12), nance (+10%) and industry (+9%).
As highlighted in our recent Quarterly Bulletin article, the expansion of employment in the last two years has been
fuelled by a large expansion of the labour force, which grew from 2.43 to 2.68 million between 2019 and 2022.
This increase in labour force participation, in the main from already resident working-age population, more than offset
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the temporary decline in net migration in 2021 due to the pandemic. Labour force participation rates in Ireland have
increased right across the age distribution, although the increases for women - up by almost 4 percentage points to 60
per cent - and younger and older workers are particularly large.
Central Bank research shows that the participation expansion supporting employment growth is mostly explained by
two factors: (1) a tighter labour market, which has boosted participation among younger age cohorts more sensitive to
prevailing economic conditions; and (2) longer run trend increases in participation for some groups. In relation to the
latter, the analysis suggests that the higher levels of participation for women could be sustained, providing a boost to
overall labour supply and supporting economic growth over the medium-term. The participation gains for under 25s
could also be maintained as these cohorts are contributing labour alongside educational attainment, however, this
activity is more sensitive to the economic cycle.
We see similar changes in labour force participation in other euro area countries, which, when combined with falling
unemployment rates, are contributing to higher employment rates in some countries such as France, the Netherlands,
Italy and Spain.
Will these labour supply effects persist? Or will they fade as the pandemic-rebound eases? Are these structural or
cyclical changes?
Our current analysis of the Irish data suggests that cyclical factors are dominating. However, the pandemic has induced a
rapid and signicant shift in long-established work practices, notably the increase in working from home in jobs where
this is possible. And whilst we have yet to see any evidence of the increased incidence of working from home as being a
dominant factor explaining the increase in labour force participation in Ireland, we should consider some of the potential
longer term effects of the greater use of exible working.
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For example, we know that women are more likely to work from home than men. In Ireland, one-in-four workers now
say they work 'mainly from home', up from just one-in-fourteen pre-pandemic.
Working from home is also more common in certain cohorts of the population: 40% of workers aged 40-plus say they
work at least 'sometimes at home', compared with just 20% of workers under 25; almost 50% of workers in the top
quartile of the wage distribution work at home, compared to 25% of workers in the bottom quartile of the
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distribution.
The implications of more home-working go beyond labour supply. It could also matter for wages if the increased
'amenity value' of working from home is shared between employees and employers. What do I mean by 'amenity value'?
It includes many things, such as the benets of reduced commuting time, greater ability to exibly plan time use during
the day, more autonomy in work, and less trafc-related stress.
In the US, researchers have attempted to quantify these amenity values for workers and nd that they range from
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around 1.5% to 7% of earnings as you move up the pay distribution. The potential impact on wages is via wage
bargaining, as employers and employees increasingly bargain over the value of the option to work from home. The
upshot is that increased working from home could be reected in lower wage levels than would otherwise the case, with
implications for wages, the distribution of market income and ultimately the labour share. These are, of course,
essentially arguments about the wage level, as opposed to wage growth.
Beyond working from home, there are other forms of exibility introduced in response to the pandemic which could
impact the labour market. For example, we have highlighted more remote education or training opportunities as a
potential force for increased labour force participation for certain groups. We already see this in the share of under 25s
working whilst also 'in education' which, in recent quarters, has risen from pre-pandemic levels. We saw similarly high
cyclical rates of youth labour force participation during the mid-2000s. However, one important difference now is that
more of these workers are combining both education and work, whereas before it was more a case of leaving education
for work. Sector shifts - that is, fewer construction workers - is likely part of the reason, in addition to greater
opportunities for remote work and study. Beyond the income benets to these workers, there are also potential longer-
term benets in being able to combine both work and training. One is higher average labour market productivity.
Another is shorter unemployment durations in the event of a job separation, which could in-turn have implications for
cyclical unemployment dynamics.
... the outlook for wages
The near-term outlook for wages depends on three inter-woven factors: (1) tightness of the labour market, and how it is
expected to evolve; and (2) how much, and over what time period, will employers adjust nominal wages to reect the
current bout of ination - in other words, real wage catch-up, which itself also depends on tightness; and (3) the future
path for ination and how this impacts ination expectations and future wage demands.
Notwithstanding the deterioration in the outlook during 2022 - due in large part to the hit to real incomes from ination
- indicators continue to point to a very tight labour market. The unemployment rate is either at, or very close to, historic
lows in many euro area countries, and reports of labour shortages by rms persist. The number of job openings (or the
job vacancy rate) has retained much of its post-pandemic high, and are around 50 per cent above pre-pandemic levels.
The boost in demand for 'pandemic-related' jobs - notably in the delivery and transport of goods - has been particularly
strong. And whilst the total number of job openings has held up so far in Ireland, we are seeing declines in some sectors,
such as technology-related jobs, which is following a similar decline in the US. This will inevitably bring both uncertainty
and challenges for individuals and households.
This inverse relationship between job vacancies (on the y-axis) and unemployment can be shown in the Beveridge curve,
which I plot here for the euro area. Cyclical economic variation is marked by movements along the curve, whereas
structural changes - such as a change in job matching efciency - shift the position of the curve. My reading of the
recent data for both the euro area and Ireland points to cyclical factors as the main drivers of labour market tightness,
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which supports the case for higher interest rates to sustainably bring ination back to our 2% target.
What's happening to wages in this environment?
First, I think it is useful to look at wage dynamics before the pandemic hit. Up to 2019, nominal wages were growing at a
rate equal to ination plus around 1%. This meant real wages were broadly tracking (domestic) productivity growth
which, according to the CSO , also averaged around 1% per year up to 2020.
For this year, as outlined in our October Quarterly Bulletin, we are projecting average nominal wage growth of 3.8%,
accelerating to 5.8% in 2023, before falling back slightly to 4.9% in 2024. A combination of a tighter labour market and
real wage catch-up are driving this growth. Thus, the expectation is for more real wage catch-up to occur in 2023 and
2024, but real wage growth to be negative in the short-term. This is consistent with survey evidence collected by the
Central Bank, which showed that the majority of workers expected wages to increase by less than ination during
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2022.
Despite considerable uncertainty in the economic outlook for the euro area, nominal wages are projected to grow at
around double historical rates, of 4.0%, 4.8% and 4.0% between 2022 and 2024. Emphasising the scale of the challenge
facing both workers and rms in adjusting to the price shock, in both the Ireland and the euro area cumulative real wage
growth is still projected to negative (on average) by 2024: around minus 3% in both cases.
How do these projections compare up with the latest data?
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For Ireland, National Accounts estimates show growth in compensation per employee of around 2.8% in Q2 2022.
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Other estimates by the CSO, from rm surveys, give a similar gure of 2.7% in Q2 2022, up from 2% in Q1. One
potential issue with these gures is that they do not take account of signicant changes in the composition of
employment as we emerge from the pandemic, and which could skew wage growth estimates. To lter out some of these
compositional changes, the CSO also reports estimates that condition on the same workers working in both Q2 2021
and Q2 2022 (but not necessarily in the same job). This gives a very strong estimate of 9.3% for annual wage growth in
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Q2 2022.
For the euro area, the ECB's own timely wage growth tracker is based on negotiated wages . The latest observation for
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annual growth in negotiated wages in the euro area, in Q2 2022, is 2.14%, down from 2.84% in Q1.
From the perspective of understanding both current and future wage dynamics, none of these measures are perfect,
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with potential issues relating to composition, coverage and representativeness. Another drawback with the ECB
negotiated wage series is that it tends to lag economic developments by several quarters.
Therefore, to complement these ofcial wage data, as well as to get a more timely and forward-looking picture wage
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developments, we also analyse trends in posted wages in job ads using data from the job site Indeed. In the current
tight labour market data, wages of (potential) new hires have received a lot of attention, both as a leading indicator of
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average wage growth in the economy and as an indicator of labour market tightness. The wage tracker was built to be
responsive. Available shortly after the end of each month, it's much more timely than existing sources. It can help shed
light on future trends because it tells us how much employers expect (and are willing) to pay to hire an additional worker.
Post-pandemic, growth in posted wages has picked up sharply. As of October 2022, we estimate average annual growth
in posted wages of just under 4.7% in Ireland and 5.2% in the euro area. Given its contribution to overall employment,
the euro area trends is heavily inuenced by wage growth trends in Germany, which hit 7.1% per year in October. In
Ireland, wage growth in recent months has either plateaued or slowed, suggesting that employers maybe taking stock of
the weaker demand outlook.
In the same way that we think about how broad price pressures are, we can also analyse how broad these wage growth
trends are. In the year to October, six out of 10 occupational categories in Ireland and the euro area, saw wage growth
in excess of 3% - a rate of nominal wage growth rate that is roughly consistent with a 2% ination target plus 1%
productivity growth. This share is well above the 2019 average of four out of 10 occupational groups, and suggests
higher wage growth is becoming more spread out, rather than being driven by a small number of job categories where
the supply-demand balance is tight. Such a broadening of upward wage pressures could be evidence of growing 'second-
round' effects of energy and food price shocks on ination, and is no doubt a trend we will be paying close attention to in
coming months.
Conclusion
In my conclusion, I will consider the outlook for ination, focusing on the main drivers of ination I have already
mentioned.
On the policy front, I will briey touch on the distributional aspects of high ination, and what this means for scal
policy. But my main focus will be on the task monetary policy makers face in bringing ination back to target.
Looking ahead: global price pressures from supply bottlenecks gradually easing, a rebalancing of
demand towards services, and uncertainty around energy prices and the growth outlook
When ination is high it tends to be unstable and hard to predict. And so it has proven with the ECB's own projections -
and it is not alone in this - which have systematically under predicted even the near-term path for ination in recent
quarters. Much of the under-prediction is from unexpected energy price shocks, and in these circumstances it makes
sense to include scenario analysis alongside baseline projections, as the ECB has done recently.
However, it is not only volatile energy prices that explain the under-forecasts. At least initially, there was also an under-
appreciation of the other ination drivers I highlighted previously - such as the shift from services to goods, and the
persistence of supply shocks and bottlenecks combined with strong pent-up demand.
In the near-term, the energy crisis will continue to support higher price levels, whilst also being negative for growth. But
as the base effects recede, and conditional on future shocks, I would also expect the upward pressure on ination from
en