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The writer is Visiting Professor at Cardiff Metropolitan University and an associate at Independent Economics
Inflation and the cost of living crisis are now perceived as the most pressing problems facing economic policymakers. Fears that this will prove persistent and trigger a wage-price spiral have motivated the Bank of England to raise interest rates from negligible levels to 5.25 per cent.
An important component of the surge in inflation was the rise in import prices as global energy and food costs soared with the outbreak of war in Ukraine. At one point last autumn that price surge ─ a sharp fall in the UK’s “terms of trade” ─ subtracted about 1.5 per cent from the country’s national income.
However, the surge, which drove consumer price inflation to annual rates above 10 per cent, has now fully reversed. Indeed, the terms of trade are now slightly better than they were at the beginning of 2022.
Consequently, inflation is falling fast: consumer prices in the month of June rose at an annual rate below 2 per cent, and in July the CPI index fell by 0.4 per cent, mainly owing to a decline in energy prices.
The initial concern was that the UK had suffered an inescapable loss of real income as import prices rose, and that if companies and workers were to attempt to restore their previous levels of income, the result would be a wage spiral. The spectre of the 1970s loomed, when terms of trade loss and the subsequent battle over income shares resulted in persistent double-digit inflation.
That fear is now obsolete, given the terms of trade recovery, but it has mutated into worries about the scale of wage increases and the prospect that they will perpetuate core inflation above the target rate.
These are understandable concerns, but they need to be seen in context. Real wages are down 4.5 per cent since the beginning of 2022, having failed to keep pace with inflation. There has been a concomitant increase of some 5 percentage points in the share of corporate profits in national income. Household incomes have been supported by large government subsidies. Yet by all accounts labour markets are tight, so there is no reason to expect the share of wages to fall to such an extent. It must be expected, therefore, that increases in average earnings will run ahead of price increases for some time, and it is appropriate that they do so. To call for wage restraint to lower inflation at this juncture is simply a demand for salary cuts.
Of course, all this has a sectoral dimension. Profit margins are up where wholesalers or retailers were marking up on higher input prices. If they hold prices when these costs fall, their margins will increase further. While the beneficiaries are probably concentrated in the energy and food sectors, the effect is felt on real wages in all sectors. Employers will face wage demands. If they concede and raise prices, inflation continues — unless prices fall in those sectors where profit margins have risen. This is happening in energy and to a lesser extent in food. It is to be hoped that importing and retailing of food and energy are competitive enough for that to continue.
The policy judgment now has to be whether employers will respond to the inevitable above-inflation wage demands by attempting to preserve past improvements in profit margins. That obviously depends on the strength of demand and activity in the economy. The picture is clouded by the long and variable lags in monetary policy. The effect of interest rate increases on the cost of consumer credit has been quite rapid, but that on mortgages has been delayed while fixed-rate contracts work through. There are tentative signs of a slowdown in activity and a slackening in the labour market; longer leading indicators such as money supply point in the same direction.
The BoE should be less concerned about bearing down on wages and cautious about further restriction.
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