Globalisation and the Decoupling of Inflation from Domestic Labour Costs

TL;DR

This paper provides cross-country evidence that the connection between domestic labour costs and inflation has significantly weakened in advanced economies over recent decades, largely due to increased import competition and trade openness.

Contribution

It offers novel empirical evidence quantifying the decline in inflation pass-through from domestic labour costs to CPI inflation and links this to increased import penetration and market contestability.

Findings

Short-run pass-through decreased from 0.25 to 0.02 between the 1980s and 2010s.

Long-run pass-through decreased from 0.36 to 0.03 over the same period.

Trade openness and inflation levels non-linearly affect pass-through strength.

Abstract

We provide novel systematic cross-country evidence that the link between domestic labour markets and CPI inflation has weakened considerably in advanced economies during recent decades. The central estimate is that the short-run pass-through from domestic labour cost changes to core CPI inflation decreased from 0.25 in the 1980s to just 0.02 in the 2010s, while the long-run pass-through fell from 0.36 to 0.03. We show that the timing of the collapse in the pass-through coincides with a steep increase in import penetration from a group of 10 major manufacturing EMEs around the turn of the millennium. This signals increased competition and market contestability. Besides the extent of trade openness, we show that the intensity of the pass-through also depends in a non-linear way on the average level of inflation.