Inflation has dominated the summer’s economic headlines. Both the old RPI and
the new CPI measures are above their respective targets (2.5% and 2.0%
respectively), at 3.1% and 2.5%. With GDP growth in the second quarter coming in
at an above-trend 0.8%, interest rates were raised for the first time in two
years in August, to 4.75%.
The key issue influencing future rate movements is how real is the inflation
threat? Are the current numbers a precursor to an energy-induced upward surge in
prices that will fuel higher wages and revive the old wage-price spiral? Or do
the current data give a misleading view of what is happening, suggesting that
the current nervousness is overdone?
There are various routes by which inflation can come into the economic
system. Companies, for example, have been faced with higher input costs, for raw
materials and energy in particular. In the first half of this year, these costs
were up almost 14% in 12 months. Yet these same companies’ output prices
increased by only 2.9%, indicating that they found some way to absorb the higher
costs. Containing labour costs, reducing headcount, or squeezing margins are the
most obvious ways to avoid passing on higher costs in higher prices. The
intensely competitive nature of most markets in the UK make containing prices an
imperative for most managements.
Households have also been in the firing line with double-digit rises in
energy bills, not just for petrol, but also for gas, water and electricity,
increases that have bitten deep into disposable incomes. Today, energy costs
account for half of CPI inflation. The rate excluding energy (‘core’ inflation)
would be just 1.1%, down from 1.6% six months ago. Unless there is another hike
in prices, the influence of energy on the annual rate will drop out of the
numbers in the next few months.
So, while the inflationary pressures are clearly there, companies are trying
to manage them and households may already have seen the worst of them. For the
policymakers, however, it is the ‘second round’ effects that matter. In other
words, will higher prices lead workers to demand higher earnings, which, in
turn, will add another upward twist to costs? To many people’s surprise, the
labour market has been very benign and shows no sign of responding to a pick up
in the inflation rate.
Even when unemployment was falling and employment was rising, the annual rate
of earnings growth stayed within the Bank of England’s comfort zone of 4.5%.
There were three main reasons for this. First, the industrial relations
legislation of the 1980s reduced the likelihood of a return to the bad old
practices of the 1960s and 1970s. In the second place, growth has largely been
in the less-unionised service industries, with manufacturing, the stronghold of
traditional trade unionism, diminishing in size. Finally, the influx of migrant
workers, particularly in sensitive sectors such as construction, meant the
supply of workers broadly kept pace with the increase in the number of available
jobs, helping to keep a cap on earnings growth. Now that unemployment has
started to rise and the labour market is loosening, these ‘second round’ effects
are even less likely to come through.
The argument for raising base rates looks a lot weaker in this context. If,
moreover, higher energy costs are regarded as equivalent to an increase in tax
on consumers, they will have the effect of slowing GDP growth by eating into
discretionary spending power. Viewed in these terms, the case for reducing base
rates is stronger.
Those of a certain age must be wondering what all the fuss is about. In the
1970s and 1980s, Britain had proper inflation, something you could get your
teeth into, with prices at times rising by 20% a year or more. Nowadays, we seem
to get worked up about the first number after the decimal point. In the old
days, interest rates used to go up in 2% jumps, sometimes doubling in a little
more than a year. Today, we agonise about moving them by one quarter of one per
cent, something the MPC has done only twice in two years. With Denis Healey at
the Treasury, policy management was a white-knuckle ride on the back of a
Vincent 1,000 without a crash helmet. Now, with Mervyn King at the helm, we are
pootling along in the slow lane in a Ford Fiesta, seat belts on and listening to
Abba on Radio Two.
The current inflation focus is not, however, an over-reaction. Having a
little bit of inflation is like being a little bit pregnant – it soon becomes a
bigger bit, and, before you know it, base rates are moving quickly upwards,
destabilising the economy in the process. If anyone doubts the effectiveness of
current policy, they need only to remember that the UK has now recorded 56
consecutive quarters of growth (14 years), a period of sustained growth
unprecedented since records began in 1870. As a result, we are enjoying the
country’s highest ever employment and it is now five years since base rates last
reached 5%. Worrying about the first digit after the decimal point at least
ensures the first digit before it does not become a problem.
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