Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
Excessive wage increases are increasingly being framed as the sole cause of a UK inflation problem that is causing mortgage difficulties and forcing families to make tough choices with their shrinking purchasing power.
While this message gained traction recently due to the latest wage data and inflation warnings from the UK chancellor and the Bank of England, it is partial and can easily mislead. It oversimplifies the inflation challenge and the appropriate policy response. It also increases the risk of economic stagnation, further exacerbating the current inflation and interest rate predicament.
The current phase of high UK inflation is similar to advanced countries’ experience in the 1970s and 1980s. Initially driven by a few factors (energy and food in this case), it leads to broader price increases across the entire goods sector before impacting on services. Consequently, inflation does not fall rapidly even after the initial shock has subsided. Meanwhile, the process itself fuels and is fuelled by wage growth which is less sensitive to interest rate rises.
According to the latest data, annualised wage growth for the three-month period ending in May was 7.3 per cent, surpassing the consensus forecast of 7 per cent. Private sector pay rose by 7.7 per cent, outpacing the public sector’s 5.8 per cent. The data release pushed market interest rates higher, while mortgage providers, reacting to previous rate increases, raised the average two-year mortgage rate to over 6.6 per cent, a level not seen in 15 years.
The data followed the calls for wage restraints from both the chancellor Jeremy Hunt and BoE governor Andrew Bailey at the Mansion House gathering of high-level representatives from the finance industry and elsewhere. Bailey also kept the door open for a second consecutive 0.5 percentage point interest rate hike at the upcoming meeting of the Bank’s Monetary Policy Committee.
The UK inflation debate now focuses excessively on wage-push inflation, where providers of goods and services pass on higher wage costs to consumers. This is unfortunate for three reasons.
First, it comes at a time when real wages have already been significantly eroded by an inflation that peaked above 10 per cent. Even the latest wage gain, although high in nominal terms, falls short of the May consumer price inflation of 8.7 per cent.
Second, the drivers of inflation are more complex and diverse than just wages. They include the initial timid policy response to what was mischaracterised as “transitory” inflation by most central banks; disrupted international supply chains; a tight labour market; and the prioritisation of profit margin maintenance by some companies.
Third, focusing excessively on wage restraint as the main tool for reducing inflation increases the probability of a recession. It would undermine household demand at a time when high mortgage costs are already placing a significant burden on households. Economic activity, as well as the provision of essential public services, is also vulnerable to strike action.
It may be tempting to perceive these problems as uniquely British given that inflation is running at more than twice the US level and above that in the eurozone, and wages are increasing at a faster pace. This inclination is amplified by the country’s historical tendency towards industrial action and more stubborn resistance to real wage erosion, albeit dating back decades.
However, given the strength of the services sector in all three economic regions, there is a substantial risk that the US and the eurozone may eventually adopt a similar framing of the challenge and solution to inflation. This would further impede global growth, which is already hindered by a disappointing economic recovery in China.
The UK should lead others in implementing a more comprehensive policy response. This approach should complement interest rate hikes and wage restraints with meaningful measures to invigorate the supply side. It should take advantage of the necessary energy transition, embrace exciting technological innovations and reassess the best path to taking inflation to a low and stable level.
Such an approach would not only reduce the risk of stagflation but also enhance prospects for sustainable productivity growth and expand the country’s growth potential. It would provide a better chance of tackling the long-term challenges posed by climate change, high debt, low growth, and the excessive inequality of income, wealth and opportunity.