Lower real wages translate to reduced labor costs. This may explain part of the strength of the labor market despite slowing growth. But in many countries, the observed increase in employment goes beyond what the decline in labor costs would suggest. It is fair to say that the reasons are not fully understood.
If labor markets remain strong, we should expect—and welcome—real wages recovering lost ground. This means nominal wage growth will remain strong for a while even as price inflation declines. Indeed, the gap between the two has started to close. Because average firms’ profit margins have grown robustly in the last two years, I remain confident that there is room to accommodate the rebound in real wages without triggering a wage-price spiral. With inflation expectations well-anchored in major economies, and the economy slowing, market pressures should help contain the pass-through from labor costs to prices.
These labor market developments matter enormously. In the near term, should economic conditions deteriorate, the risk is that firms might reverse course and sharply scale down employment. Separately, the strong recovery in employment, coupled with only modest increases in output, indicates that labor productivity—the amount of output per hour worked—has declined. Should this trend persist, this would not bode well for medium-term growth.
Despite monetary policy tightening and the slowdown in bank lending, financial conditions have eased since the banking stress in March. Equity market valuations surged, especially in the artificial intelligence segment of the tech sector. The dollar depreciated further, driven by market expectations of a more benign path for US interest rates and stronger risk appetite, providing some relief to emerging and developing countries. Going forward, there is a danger of a sharp repricing—should inflation surprise to the upside or global risk appetite deteriorate—causing a flight toward dollar safe assets, higher borrowing costs and increased debt distress.
Policies
Hopefully, with inflation starting to recede, we have entered the final stage of the inflationary cycle that started in 2021. But hope is not a policy, and the touchdown may prove quite tricky to execute. Risks to inflation are now more balanced and most major economies are less likely to need additional outsized increases in policy rates. Rates have already peaked in some Latin American economies. Yet, it is critical to avoid easing rates prematurely, that is, until underlying inflation shows clear and sustained signs of cooling. We are not there yet. All the while, central banks should continue to monitor the financial system and stand ready to use their other tools to maintain financial stability.
After years of heavy fiscal support in many countries, it is now time to gradually restore fiscal buffers, and put debt dynamics on a more sustainable footing. This will help to safeguard financial stability and to reinforce the overall credibility of the disinflation strategy. This is not a call for generalized austerity: the pace and composition of this fiscal consolidation should be mindful of the strength of private demand, while protecting the most vulnerable. Yet, some consolidation measures seem entirely appropriate. For instance, with energy prices back to their pre-pandemic levels, many fiscal measures, such as energy subsidies, should be phased out.
Fiscal space is also key to implement many needed structural reforms, especially in emerging and developing economies. This is especially important since prospects for medium-term growth in income per capita have dimmed over the past decade. The slowdown is sharper for low- and middle-income economies relative to high-income ones. In other words, prospects for catching up to higher living standards have diminished markedly. At the same time, elevated debt levels are preventing many low income and frontier economies from making the investments they need to grow faster, with high risks of debt distress in many places. Recent progress toward debt resolution for Zambia is encouraging, but faster progress for other highly indebted countries is urgently needed.
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