Immigration the key to lower inflation in labour-scarce rich world

When advanced economies keep raising rates, emerging markets like India are also constrained to raise their own policy rates. (Source: Reuters/Representative )

An examination of the decision-making process at major central banks shows that these bodies, while continuing to raise policy rates of interest, are all constrained by rising wages in a tight labour market, marked by historically low rates of unemployment. They, therefore, do not see an early end to inflationary pressures and promise to keep on raising rates till their goal of containing inflation at 2 percent is achieved. The way out of the vicious spiral of wages rising faster than productivity and, thereby, feeding inflation is to increase the labour supply via more liberal immigration policies. That, however, is not on the policy agenda. And the G20 dos that India has been hosting have not particularly flagged this issue either.

When advanced economies keep raising rates, emerging markets like India are also constrained to raise their own policy rates — failure to do that would depreciate local currencies and raise the import prices, including of oil and gas, thereby worsening inflation. Higher interest rates dampen growth at a time when developing economies need desperately to grow, coming out bruised from the pandemic and its terrible toll on lives and livelihoods.

The Indian economy, at the end of 2021-22, stood 2.9 percent higher, in real terms, than it was in the pre-pandemic 2019-20 — Gross Value Added in these two years, at constant prices, were, respectively, Rs 1,32,19,476 crore and Rs 1,36,05,474 crore (figures from the latest Economic Survey). As population grew from 135.3 crore to 138 crore over the same period, average real per capita income grew by less than one percent over two years, or less than 0.5 percent a year. Thanks to the decline in India’s population growth rate to just over one percent per year, even when growth had plummeted to 3.8 percent in 2019-20, per capita income had risen by 2.8 percent. This, of course, is about averages. If one factors in the differential impact of an economic crash, such as in the pandemic-afflicted 2020-21, on the well-off and the poor, it is reasonable to assume that per capita incomes of the bottom deciles of the population had actually declined and have not recovered since the pandemic.

If this is the case in a lower middle-income country like India, things are likely to be worse in low-income countries of the world.

War hurts developing world

There are those who argue that by continuing to supply weapons to Ukraine and feeding the false hope that Ukraine would be able to defeat Russia, the rich nations are needlessly putting off peace talks and prolonging economic uncertainty and price volatility across the world. Some would dispute this. But what is indisputable is that by ratcheting up interest rates in a bid to contain inflation, without doing anything to ease labour supply, the rich world is throttling growth in the developing world and heaping manmade misery on the misery created by a virus that ran amok.

Let us look at the centrality of tight labour markets in persistent inflation. Those employed in the economy constitute the workforce. Everyone in the age group considered fit to work is not available to work: some are in education or training, some are retired and some are in-between jobs. Those available for work, even if they have not found work, constitute the labour force. The labour force consists of the workforce and those who are looking for work but are unemployed.

When interest rates are raised to contain inflation, it is expected to work by dampening economic activity, lowering the demand for labour, so that wages would rise slower than prices, effectively depressing consumption and reducing the demand for goods and services. Some workers would be laid off, and would swell the ranks of the unemployed. Economic slowdown and recession kill inflation with a rise in unemployment as a natural corollary. And when the economy regains vigour after inflation has been contained, the ranks of the unemployed would deplete, to add to the workforce. This is the theory.

Suppose unemployment does not rise and wages do not trail the rate of price rise, even after interest rates have gone up. The only way inflation can fall in this situation is if productivity were to go up, so that output (value added) would go up faster than the wage component. Raising productivity calls for investment. But investment is dissuaded by higher rates of interest. Employment that stubbornly refuses to fall even as interest rates go up, scuppering productivity-enhancing investment, erodes the ability of higher rates to kill inflation. So interest rates keep getting raised, attempt after failed attempt to kill inflation with a rise in the interest rate.

Central banks on labour markets

Let us see if this has been happening in the rich world. Let us start with the minutes of the United States’ Federal Open Markets Committee that raised policy rates by 25 basis points at its last meeting, bringing them up to 4.5-4.75 percent. “The information available at the time of the January 31­-February 1 meeting indicated that labour market conditions remained tight in December, with the unemployment rate at a historical low... Total nonfarm payroll employment increased solidly in December, although at a slower pace than in the previous two months. The unemployment rate moved back down to 3.5 percent in December…

“Measures of nominal wage growth slowed at the end of last year but continued to be elevated. The three-month change in the employment cost index (ECI) of hourly compensation in the private sector slowed to a 4.0 percent annual rate in December, while the three-month change measure of average hourly earnings (AHE) for all employees eased to an annual rate of 4.1 percent. Over the 12 months ending in December, the ECI increased 5.1 percent, and AHE rose 4.6 percent.

The story is repeated in the minutes of the Bank of England’s Monetary Policy Committee at its last meeting.  “The LFS (labour force survey) unemployment rate had remained at a historically low level of 3.7 percent in the three months to November, and in the February Report forecast was projected to rise only gradually over the course of the year. Many of the Agents’ business contacts had reported that they were reluctant to reduce headcount actively, and intended to accommodate weaker demand through attrition or by reducing working hours”.

The story is the same for the European Central Bank. “Rising wages and the recent decline in energy price inflation are also set to ease the loss of purchasing power that many people have experienced owing to high inflation…” Thus did ECB president Christine Lagarde spin the failure of past rate hikes to dampen wage growth as a positive feature. Further, “(t)he unemployment rate remained at its historical low of 6.6 percent in December 2022. However, the rate at which jobs are being created may slow and unemployment could rise over the coming quarters,” she hoped, and went on to say that “The Governing Council will stay the course in raising interest rates significantly at a steady pace and in keeping them at levels that are sufficiently restrictive to ensure a timely return of inflation to our two per cent medium-term target. Accordingly, the Governing Council today decided to raise the three key ECB interest rates by 50 basis points and we expect to raise them further.”

Tight labour markets in the rich world deflect the killer blow higher policy rates are supposed to deliver to domestic inflation, and direct it to jobs in the developing world, whose growth prospects are maimed by higher policy rates in the rich world that poor country central banks are forced to imitate, lest they import inflation via depreciated currencies.

Looser immigration policies would let in additional workers at all skill levels to loosen the labour supply in the rich world, allowing flexible labour markets to complement interest rates as they soar to strike down inflation. In the absence of immigration, interest rates will have to keep rising for a long time.

TK Arun is a senior journalist. Views are personal and do not represent the stand of this publication.