Blips could pave the way for paying all over again
Monday 06 February 1995
"Blip" was his way of dismissing concerns that the boom-induced rise in inflation then under way would get out of hand; he regarded it as no more than a temporary deviation from the true path of long-term price stability. Alas - as he now knows and as a very few of us predicted - the inflation metamorphosed into a tenacious blob that succumbed only when the economy collapsed.
The official lexicon of blips, pops and bumps is likely to be pressed into hyperactive service in the months ahead. Headline retail price inflation will suffer from a number of genuinely one-off shocks. Higher mortgage rates, budget excise taxes, raw material costs and an abatement of the retail margin squeeze that so effectively reduced high street prices last year will together have a marked effect. The headline inflation rate could jump rapidly to 4 per cent or more by the spring, over a percentage point up on December's figure.
Although still low by British standards, any rise in inflation is unwelcome when many pay deals are struck. According to the large sample of settlements monitored in the UBS databank, workers accounting for no less than 55 per cent of the workforce usually reach agreement on annual pay levels in the January-April period. If pay negotiators take the jump in headline inflation as a base line from which to seek higher real reward, the blip in inflation may well turn into something more protracted.
But surely it is all going to be different this time? After all, the economy has just enjoyed two years of remarkable growth and inflation surprises; the balance of payments has moved into official surplus and unemployment is failing rapidly. Add to thismiracle of economic transformation a policy-making machine bent on not repeating the Lawson errors and the prognosis must be favourable? I beg to differ.
Take the labour market. It is commonly argued that the conjunction of falling unemployment and low pay rises is positive proof of a radical improvement in labour market behaviour. The inference is not justified, however. Low pay inflation may be the consequence of the downward shock to price inflation administered by the early 1990s depression and Britain's fleeting marriage with the European exchange rate mechanism.
It is the behaviour of real, inflation-adjusted, wages that needs to be examined. The question can be formally stated this way: as economic conditions change, is the real value of pay that employees seek and employers hope to grant more responsive today than when unions were more powerful and welfare benefits more generous?
Perhaps surprisingly there is little evidence of improvement. All those Eighties labour market refoms may well have helped raise industrial productivity but they do not appear to have had a significant influence on pay-bargaining behaviour. Recent research by my colleague, Andrew Cates, suggests that pay developments today are following a time-honoured pattern - rising in real terms as national productivity levels rise and as unemployment falls. His work shows real wage developments since Britain's ERM departure are little different from what one would have predicted on the basis of previous experience.The sharp tightening of the labour market therefore poses a problem for the chancellor. As in the Lawson boom, the recent rapid fall in unemployment will, with a time lag of over a year, raise the level of real wages demanded by employees. At the same time companies, awash with cash, are well-positioned to pay up. Add the impact of the blip in retail price inflation and you can begin to imagine a serious escalation of cash pay following last year's quiescence. At this stage of the cycle, rising pay will often go with declining rates of productivity advance, pushing up unit costs and price inflation.
If the labour market does not provide much comfort, what about the balance of payments? Does not the shift into surplus signify fundamental improvement, a supply-side miracle? Again the answer is probably no. This response might sound like sour grapes from a forecaster who, like many others, failed to predict the trade improvement. But the scepticism is quite objective. The unexpected export boom that transformed the trade account has exposed the structural weakness that underlay my original concerns.
The point is simple: Britain's manufacturing industry which accounts for two-thirds of the economy's international trade is efficient but too small-scale. On my reckoning, manufacturers' capital stock has hardly grown since the end of the 1970s, even allowing for the improved quality of investment. The volume of consumers' aggregate spending by contrast has risen 50 per cent. Consequently, it is no surprise to discover that 1994's export boom pushed many manufacturers to the limits of their physical capacity. Overall capital utilisation rates are as high as they were in the booms of the 1960s, early 1970s and mid-1980s, though not yet at the heady heights seen during the Lawson Experience.
With capital-shortage has gone a search for high rates of return. Manufacturers' profit margins, while volatile, have traced an historic path closely guided by the high and rising level of capital utilisation. And it is the search for ever-higher marginsthat fundamentally lies behind the signicant upturn in producer price inflation. After a low point last summer, a few months ahead of the low point of retail price inflation, underlying producer prices jumped to an annualised income of 4.5 per cent in the final quarter of last year.
In labour and product markets, Britain is beginning to experience a typical inflation spiral; the rising real income aspirations of workers colliding with the rising margin expectations of producers when the economy is less able to accommodate either. Itis a veritable battle of mark-ups, a view of the inflation process first properly articulated by a Cambridge economist, Professor Robert Rowthorn.
That battle might be avoided by inflation-aware policy-makers who push up interest rates before matters get out of hand. To describe such pre-emption, Governor Eddie George uses the homely analogy of a stitch in time to save nine: the latter figure a neat reference to the current expectation priced into the futures market regarding next year's level of interest rates.
Yet you can understand the logic of the market position. The economy has entered overheating territory with a still-high growth rate, a politically-embattled government and a private sector with an unprecedented surplus of spare cash to spend
So when the word offensive of blips and bumps begins, my advice is to hide the silver and head for the hills.
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