Jeremy Warner's Outlook: The shape of the coming wage round will determine the Bank's next move on rates

Airline mergers become all the rage; Reits: another first for British Land
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The Independent Online

The prospects of another interest rate rise grew sharply yesterday after data showing that earnings growth is accelerating again while unemployment is once more on a declining trend. Coming so soon after the latest inflation figures, with prices rising at their fastest rate since Labour came to power, the new data is bound to set alarm bells ringing among members of the Bank of England's Monetary Policy Committee (MPC).

Yet it is the earnings and unemployment figures, rather than the inflation numbers, that will be of most concern to the MPC. The MPC targets inflation not as it is, but as it is forecast to be two years hence. The current inflationary blip is not yet over. There may be worse still to come. Even so, all other things being equal, inflation is eventually expected to abate back towards target as higher utility and fuel bills work their way out of the system.

The only sense in which the currently high rates of inflation affect policy is if they lead to second-round effects by raising inflationary expectations and thereby acting as a yardstick for pay settlements. For many middle-class Londoners, with school fees and ever-rising house prices to pay for, the official numbers already seem hopelessly to understate the reality. Their own rates of inflation are much higher. Though the indices that measure inflation are meant to be an average for the cost of living, hardly anyone conforms to them.

Nor is this just the middle classes. Much higher rates of inflation are a reality for many low-income earners and pensioners too. For every individual experiencing these higher rates, there is presumably someone experiencing a lower one, yet it is hard to imagine who they might be. How many people do you know who spend all their money on clothes, cars, computers and flat-screen TVs, some of the items which are going down in price? OK, OK - so maybe quite a lot, but this sort of expenditure pattern hardly fits the profile of the "hard-working families" that Labour is meant to stand for.

All this is by the by. For what it is worth, the Bank of England's last inflation report showed inflation undershooting target two years hence if interest rates go up any further. Ergo, this may be the top of the cycle. Unfortunately, it is rarely that simple. The big debate on the MPC is about how much spare capacity still exists in the UK economy. Is the labour market already so tight that the currently high growth will trigger inflationary wage claims, or will immigration and high levels of low-cost competition from Asia ensure pay remains under control?

The latest earnings figures, though higher than expected, are still quite a bit below the 4.5 per cent rate the Bank reckons would definitely trigger inflation. Unfortunately, we haven't had the main season for wage settlements yet. That comes early in the new year. Unions are limbering up for some sizeable demands. Their chances of winning them depends crucially on the amount of spare labour there is in the economy. We'll know the answer to this question soon enough.

Airline mergers become all the rage

Few industries have consumed as much capital over the decades as airlines. They seem only ever to eat the stuff. Even in today's boom conditions with airline travel at peak levels, airlines collectively struggle to produce anywhere close to a decent return on capital - soaring fuel costs have in many cases more than cancelled out higher yields.

Yet hardly ever does an airline roll over and die. To the contrary, they are routinely rescued, kept alive on a drip-feed of state aid, or, as in the US, supported by protectionism and Chapter 11 insolvency laws. In the meantime, new ones keep springing up all over the place. I've just come back from India, where they are spawning like flies, and very profitable some of these newer airlines are too. It is in the old, legacy, airlines, that the problems lie.

All of a sudden, there is a wave of merger activity hitting the sector. Two of the biggest in the US, Continental and United, yesterday admitted they were in merger talks. If they succeed, they will become the world's largest airline, eclipsing the current number one, American Airlines. US Airways has recently bid $8.7bn for Delta, while the US low-cost operator AirTran Holdings yesterday made a bid for Midwest Air Group. Back in Europe, Ryanair's Michael O'Leary has taken a pop at Aer Lingus. Down under, Macquarie is bidding for Qantas.

Yet it is in the US where the real action is. Here there seems to be final recognition of the urgent need, particularly among the older legacy airlines, to cut capacity. There are more than half a dozen legacy airlines still operating in the US. Over the next year or two, that's likely to halve as a result of merger activity, allowing these airlines to begin the process of setting themselves on a competitive footing once more.

What about Europe? Well, Europe may aspire to be a single market, but it is not a single country and that makes cross-border mergers much more problematic. Most landing rights are still negotiated bilaterally between nations and then divided up between flag carriers. Most countries also still have strict ownership rules. Merge one national flag carrier with another and you certainly achieve some big cost cuts, but they would also stand to lose a great swathe of landing rights. The synergies gained would be more than outweighed by the loss of routes.

If it is difficult to merge within Europe, the rules make it virtually impossible with any flag carrier outside the EU. Some of the better placed legacy airlines, such as British Airways, talk the merits of open skies, but they don't really believe in it because they know that the squatters' rights they enjoy as flag carriers are a hugely valuable asset. They would also be history in a truly global airline industry. They'd all be wiped out by the low-cost airlines of the Middle East and Asia.

The airline industry is filled with strange ironies. One of the oddest is that such a protected sector should be so alive with entrepreneurial activity. But the biggest of the lot is that having done so much to bring about globalisation by making international travel easy and affordable, this is an industry which even today is barely affected by the phenomenon itself. No doubt it will come. But please make it slow, is what Willie Walsh, chief executive of BA, and most other legacy airlines, would say.

Reits: another first for British Land

For British property companies, this coming January 1 means more than just the start of the new year. It is also the first day on which they can convert to "real estate investment trusts", or Reits. First through the hoop is British Land, which plans to convert on day one.

It's been a long time coming. In the US and Europe, the Reits structure of property ownership has been commonplace for years. Yet it is only over the past couple of years that the UK Treasury has come to appreciate the sense of it.

Income from rental and capital gain gets taxed twice in a plc - once through corporation tax on profits and a second time on the dividends the company pays its shareholders. The effect has been to drive big property investors into direct ownership, or offshore into tax havens. Only 15 per cent of commercial property in the UK is owned through conventional property companies, against much bigger amounts elsewhere. By converting to a Reit, British Land and others bypass this double taxation, so that income can flow straight through to dividends.

The beneficial effects have probably already been discounted in the share price. British Land shares have risen 50 per cent over the past year alone. It's been a long overdue revaluation. By coincidence, the date coincides with the final departure of Sir John Ritblat, one of the titans of the commercial property scene, from the company he became the chairman of 35years ago. A big day in more ways than one.

j.warner@independent.co.uk

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