Britain has the kind of inflation rates that were typical in the 1980s but a very different earnings environment. Then, earnings growth never dropped below 7.5% because wage bargainers never believed low inflation was here to stay. Now, we have earnings growth suited to a world of negligible inflation but not the inflation to match.
There are, however, positive sides to current pay weakness. Wage restraint — including pay freezes and cuts — was important in preventing a bigger fall in employment and a bigger rise in unemployment during the recession.
It remains important now. Whenever the labour-market numbers are published, as last week, it is easy to get lost in the statistical fog. The big picture is this. Unemployment, broadly measured on the Labour Force Survey, is 2.49m, where it has been for the past 18 months.
If this sounds like a stagnant job market, that would be misleading. For unemployment to fall, the number of new jobs has to exceed the growth in the workforce. Over the past year employment has grown by 218,000. It remains below pre-recession levels but is almost 300,000 above its recession lows.
While the latest figures suggested employment dipped towards the end of last year, they also showed a 66,000 rise in the number of full-time employees. Hours worked, an important indicator of labour-market strength, rose in the October to December period, as they had done for the previous three quarters.
A lot of this is down to what has happened to pay. Wage restraint has enabled the labour market to share out jobs among a larger number of people than would be the norm in recession and early recovery in Britain. It is the other side of the pay squeeze coin.
So is the fact that, had pay rises kept up with inflation, we would be looking at a very different monetary policy picture. If earnings growth were 7.5% now, as in the 1980s, or even 5%, the Bank monetary policy committee (MPC) would not be debating whether to raise Bank rate from its historic low of 0.5%. The rate would already be well on the way up.
As an aside, I must comment on what I think is the biggest outbreak of economic misunderstanding in a long time. You see it in letters columns, in commentary and elsewhere. It is that, because the factors pushing up inflation appear to be outside the Bank’s control, such as Vat and commodity prices, raising interest rates would have no effect.
In really wince-making versions, people argue that raising rates would hit growth but leave inflation unaffected. Let us be clear. Whether the source of a sustained inflation overshoot is chancellor George Osborne, China or sunspots, the Bank could bring it down by raising rates.
It would do so by squeezing domestic inflation, perhaps even by generating deflation — falling prices — to offset these other factors. How would it do this? The easiest way to think of it is that a rise in interest rates would intensify the squeeze on household incomes, reducing demand and thus forcing firms to cut their prices by accepting lower profit margins. It would hurt, but it would work.
The MPC has decided collectively not to do this, accepting an inflation overshoot because the alternative of keeping inflation at 2% would inflict too much pain on the economy. That is its choice, and many would say it is the right one. But that is very different from interest-rate impotence. The Bank, which is keen on its educational role, still has work to do. The governor did not help last week by describing a token rise in rates as “a futile gesture”.
The other route, described by MPC hawk Andrew Sentance in a speech last week, is through sterling. If you are worried about soaring global prices, one way to limit their effect on inflation in Britain is to push the pound higher, and an easy way of doing that is through raising interest rates.
What happens to pay and the income squeeze from now on? Evidence is starting to build of modestly higher pay settlements. XpertHR, the old Industrial Relations Services, reported that while median pay settlements remained at 2% in the three months to January, the median for those in the top 25% rose from 2.3% to 3%, and nearly 70% of settlements were higher than last time.
Sentance, in his speech, pulled out a string of chunky-looking pay settlements, including JCB and Cummins Engine Company at 4.7% and Heinz at 3.9%. My sense, however, is that pay settlements are creeping rather than surging higher.
If it continues that way, there are reasons to be optimistic. Pay will not grow fast enough to hit private-sector employment growth, or scare the Bank too badly. Thus, while we can expect Bank rate to rise this year, beginning in a few months, it can happen in a controlled and gradual way.
Importantly, as far as the income squeeze is concerned, there is light at the end of the tunnel. The National Institute of Economic and Social Research predicts that real disposable incomes will fall by 0.8% this year, after dropping 1% in 2010. But in 2012 it sees a rise of 2%.
How? The Bank expects inflation to fall significantly from early next year, as some of this year’s one-off factors such as the Vat hike drop out.
Falling inflation should cross over with gently rising pay settlements, at least in the private sector, to produce the return of rising real pay. In this Micawberite economy, misery will be replaced by happiness. As long as people are patient.
My regular piece is available to subscribers on www.thesundaytimes.co.uk. This is an excerpt.
Originally published at David Smith’s EconomicsUK and reproduced here with permission.