June 23, 2008 | posted by Michael Baxter in inflation | comments (0) |

But, while assets behave as if we face a 1930s type challenge, and need to worry about deflation, our chancellor reminded us of the 1970s yesterday.

Pay restraint seems so very 1970s. It wasn’t just Labour of course; the Ted Heath government used to rattle on about pay freezes.  The lesson from that time tells us it didn’t work.

But on the Andrew Marr show yesterday, Al whipped the wage inflation horse.   “From the boardroom to the shopfloor,” he said, inflation changes must be consistent with the 2 per cent inflation target.

“We’ve got to make sure that we keep inflation under control because if we don’t what will happen is that people may get a pay increase but every penny of it will be eaten up by rising prices in the shops…Now none of us want to see that happen, it’s in no-one’s interest and that applies from the top to the bottom, public and private sector alike,” said Mr Darling. Andrew Marr pressed him on whether that meant we would be worse off this year, but, not surprisngly, he didn’t answer that. Well, actually, as Mervyn King pointed out last week, our growth in income outstripped our productivity in the late 1990s and earlier this decade, and now we are just seeing the other side of that.  So yes, we will be getting worse off.

Oil and food are more expensive because demand has risen faster than supply.     If we try to nullify the effect of higher food and oil through wage rises, then inflation will be the  result.

But the picture is muddied by the retail price index.    The index we use to measure inflation by is a full percentage point above target.  This morning, the FT said that data from IDS Pay Databank, covering the three months to April, suggests one in five pay deals were linked to the retail price index.

The truth is, the retail price index gives a much more accurate picture of inflation.  If our wages increases are linked to the CPI index, then we will indeed be getting worse off. 

June 19, 2008 | posted by Michael Baxter in inflation | comments (0) |

Well, we are sorry.   The economic debate moved into a new phase yesterday.  Maybe we are now set to go through the most critical period yet in the story of this extraordinary economic crisis.   And it has come down to that old-fashioned issue: pay restraint.   Real income is falling, will we see a wage price spiral?    Following a period of massive inflation in executive pay, trade unions are reasonably asking why their members can not receive pay rises in line with inflation.    It is a mess.

Here is the story in 10 stages.

Stage 1 – On April 25, in this column, we said that painful as it is, we will just have to accept that higher commodity prices mean we are worse off.  Providing we do that, take it on the chin, the rate of interest will stay down, and unemployment should not be affected too badly.  But, if we try and somehow avoid paying the cost of rising commodity prices, through demanding and then getting inflation-busting pay rises, interest rates will go up, unemployment will rise.

Stage 2 – On May 9 we told how, according to KPMG and Recruitment and Employment Confederation (REC), April saw the lowest rate of pay inflation during the last 57 months.

Stage 3 – On June 12 we told that average earnings, including bonuses, rose by 3.8 per cent in the year to April 2008, down from 4.0 per cent in March.    At that time, the retail price index was rising at 4.2 per cent.   Theoretically, providing  wage inflation minus improvement in productivity is no greater than the government’s inflation target, then there is no need for a rise in interest rates.    Economic productivity was up 1.7 per cent in the year.

We also said: “Unions do not the have the muscle they once did. A repeat of the winter of discontent seems unlikely.  There has been plenty of anecdotal evidence to suggest some workers at least are accepting pay cuts.”

Stage 4 – Earlier this week, Shell’s tanker drivers were awarded a 14 per cent pay rise over two years.

Stage 5 – Yesterday (June 18),  the BBC headlined a story suggesting our gas and electricity bills will rise 40 per cent by Christmas.

Stage 6 – In his letter to the chancellor, made publicly available on June 17, the Bank of England governor talked about wage inflation.  “This has been moderate up to now,” he said, but added, “The prospective squeeze on real incomes associated with higher inflation, together with the reduced availability of credit, is likely to lead to a further slowing in activity this year.  This will reduce pressure on the supply of capacity of the economy and dampen increases in prices and wages.”

Stage 7 – Yesterday, Brendan Barber, General Secretary of the TUC  said: “Our economic difficulties are caused by reckless lending by bankers and inflation comes from higher oil, food and commodity prices … Inflation and the pressure on wages will drop as the economy slows. That does not suggest we are heading for a runaway wage-price spiral.”

Dave Prentis, general secretary of Unison said: “Public sector workers have had below-inflation pay deals year-on-year. We are balloting 800,000 local government members for strike action over a 2.45 per cent pay offer and, if inflation continues to spiral, we will trigger the re-opener clause in the NHS deal and go back for more money.”

Dai Hudd, assistant general secretary of Prospect said: “If the fuel tanker drivers’ settlement represents pay restraint in the private sector, can the public sector have a little of that restraint as well?”

Stage 8 – At Prime Minister’s Question time yesterday, Tory MP Sir Michael Spicer  asked: “Why are there so many strikes at the end of a Labour government?”

Stage 9 – In his Mansion House speech, yesterday, Mervyn King said: “This year our real take-home pay will rise at a slower pace than national productivity. Rising fuel, gas, electricity and food prices, mean that average real take-home pay will stagnate this year. It will not be an easy time, and I know that some families will find it particularly difficult. But it is only a temporary slowing in the growth of our real take-home pay, and remember that this is the opposite side of the coin to the falls in prices of manufactured goods from countries such as China and India, which in the nice decade allowed our standard of living to rise at a rate faster than productivity.”

Ominously he also said: “There should be no doubt that the MPC is prepared to take whatever action is needed to return inflation to the 2 per cent target and to keep expectations of inflation in the medium term anchored to the target.”

Stage 10 – Yesterday, the minutes of the latest MPC meeting were revealed, and it emerged they considered upping interest rates.

We have been through a period of almost-obscene rises in pay for people in senior positions.    Incredulously, now MPs want an inflation-busting pay rise.    This has already created resentment.  Now we are being told we have got to accept that over the next year or two we are going to be worse off.  You can’t blame unions wanting to press for higher wages. 

Margaret Thatcher famously described unions as “the enemy within”. On this occasion, it is tempting to conclude the enemy sits higher up the hierarchy.

But, if unions are successful, and wages do rise, the Bank of England will have no choice but to up interest rates, and maybe by quite a bit.  Unemployment will rise, until wage increases stop.   Such a scenario will make a recession inevitable.

April 25, 2008 | posted by Michael Baxter in inflation | comments (2) |

You could be forgiven for concluding the government and regulators are caught between a rock and a hard place.     Inflation is back, right? It could even rise to more than a full percentage point over the Bank of England’s target this summer, enforcing another of those embarrassing letters from its governor to the chancellor.   This would suggest interest rates need to go up.     At the same time the arguments for a cut in rates are obvious and, frankly, further cuts seem inevitable.

So, on the one hand, the economy desperately needs lower rates to counteract the effect of the credit crunch. On the other hand, it needs higher rates to stop inflation in its tracks.  It has been heralded by some as a choice between 1970s-type inflation or 1930s-type depression.    What a dilemma.

It’s just that it isn’t like that at all, as data from IRS on wage inflation released yesterday shows.

It all boils down to the difference between inflation and price rises.

Prices go up if demand is greater than supply.   Inflation is a sustained rise in prices, caused not so much because demand is greater than supply, but because the dampening effect of higher prices is cancelled out by something else, creating a situation in which demand is permanently higher than supply.  

So oil goes up, wheat goes up, and then rice goes up in price.     The key to determining whether we have inflation is what happens next.   Even then, even if inflation seems to occur, we still don’t know whether the answer is higher interest rates until we examine the causes of this secondary effect of rising prices.

There are three possible scenarios, only one means higher interest rates. 

Scenario one: Commodities have been going up in price because of pressure on supply.    Higher prices should reduce demand until equilibrium is restored – prices then become flat.  Inflation has not occurred.  We are all a little worse off. This is how it should be. If there isn’t enough food or oil to go round then we should all lose out. If we don’t, something is wrong with the price mechanism. 

Scenario two: Prices continue to rise because of supply or external factors.    So, if we have had a run of bad luck, successive bad harvests, for example, constraining supply, prices will rise, but it has nothing to do with domestic demand pressures.   Prices go up, and we are worse off – and again it should be that, we can not be immune to paying the costs of bad harvests.   Alternatively, demand might be rising in other countries – this might mean demand is too high on a global scale but British consumers themselves are not putting prices under pressure. This is not a reason for higher domestic interest rates.

But scenario three is more serious.     As prices rise, we enjoy higher wages. We are not worse off.  There is no magic in economics. If prices rise because products are costing more, then we are either worse off, or deluding ourselves.  This is when inflation becomes a problem.  This is when inflation becomes a form of delusion – and once it sets in, it is difficult to stop it.

The good news came yesterday, because IRS revealed that the median rise in wages agreed by wage negotiators in the first quarter was just 3.5 per cent – below rises in the retail price index. 

Of course, current demands by teachers for above-inflation wage rises might be justified from a moral point of view, but the view that wages need to rise to keep up with price rises is just bad economics.

Normally, one would expect inflationary wages during a time of lax monetary policy.  Excess money creates the lubricant for inflation-busting pay rises.       If there is too much money floating around the system, an upward self-supporting spiral of rising prices can be created.

A credit crunch must presumably mean less money in circulation.  That’s why cuts in interest rates can be justified, and why they won’t necessarily be inflationary.

But have no doubt that higher commodity prices will hurt us – either in the form of less disposable income,  or in the form of higher inflation – leading to higher interest rates.  

There is nothing central banks can do about that.