Stephen King: Rulebook torn up as link between energy price increases and wage rises is broken

Labour market developments in the West are increasingly dependent on events in East
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The Independent Online

Most years throw up big economic surprises of one sort or another. 2005 proved no exception. At the beginning of the year, the main worries were probably the US housing market and the growth of external imbalances. Forecasters had to grapple with the possibility that the US housing market could crash, leading to a collapse in consumer spending, or that the dollar could plummet, driving up US bond yields. Neither scenario panned out: the US housing market strengthened through much of the year and the dollar staged a remarkable recovery, particularly given the lack of progress on the US current account deficit. US bond yields are ending the year only a touch higher than they were at the beginning of 2005.

The main surprises came in other areas. Across much of Asia, economic growth was notably stronger than expected. Japan's recovery gathered momentum, with encouraging signs of an acceleration in domestic demand. Both consumption and capital spending picked up, suggesting that Japan's deflationary problems may finally be drawing to a close: indeed, the Bank of Japan is already signalling that the monetary printing presses may be turned off in 2006. Elsewhere in Asia, China's growth rate remained remarkably robust throughout 2005, not far short of 10 per cent for the year as a whole. The authorities may have rebalanced the economy, with less dependence on an overheating construction sector, but there are few signs of any meaningful slowdown: better quality growth, perhaps, but certainly no growth deceleration. Meanwhile, India is showing signs of emulating China: growth in 2005 looks to be coming in at approaching 8 per cent, well above consensus expectations at the beginning of the year.

These Asian surprises are important. They have helped shape economic progress in the rest of the world throughout much of 2005. They have also created puzzles for policymakers in the US and in Europe. Asia's success has led to new challenges. The first of these, and most obvious, is higher oil prices. Whereas the oil price shocks of the 1970s were all about supply-side shocks - consequences of political events, notably the Yom Kippur war in 1973 and the Iranian Revolution in 1979 - the latest oil price increases are much more the result of stronger world demand. That extra demand is centred on developments in Asia.

The second puzzle is the impact of Asian success - and, for that matter, Central and Eastern European success - on wages and profits in the industrialised West. China, India and other developing countries are doing well in part because they are able to attract capital from elsewhere in the world: their labour costs, if you like, are a magnet for profit-maximising firms who are suddenly faced with greater choice over the geographical location of their labour inputs.

Put these two puzzles together and you end up with a third puzzle. How should central banks react when energy prices are rising but, for the same reasons, Western labour costs are falling? This relationship, after all, is something entirely new. In the 1970s, higher energy prices were always associated with higher wages: now, they're associated with lower wages.

The absence of wage pressures is a remarkable thing. We saw it last week in the UK, where inflation unexpectedly fell and wage pressures abated in surprising fashion. We're seeing it in Germany, where unions no longer have realistic expectations of negotiating substantial wage increases for their members: they recognise the mobility of capital and understand that wage moderation is the only way in which German jobs are going to be preserved. And we're seeing it in a rather different guise in the United States, where pressure to utilise the labour force more efficiently has been met not so much by wage cuts but through a further surge in productivity. In all three countries, growth in unit labour costs - wage costs adjusted for changes in productivity - has been remarkably docile.

This lack of any significant wage response to higher energy prices has left central bankers scratching their heads. The Bank of England was thinking at the beginning of 2005 about raising interest rates, fearing that increases in energy prices would unleash higher wage demands. In the event, those wage demands never materialised, and the Bank was eventually obliged to cut interest rates in August. The Federal Reserve has, perhaps, had an easier time. The US economy has been a lot more robust than the UK economy over the last 12 months and, together with a persistent rise in the headline inflation rate and a level of short-term interest rates at the beginning of the year that was remarkably low by historic standards, the Fed found it easy to justify a remorseless approach towards monetary tightening through 2005 as a whole.

The European Central Bank spent much of 2005 maintaining its traditional stance of monetary hibernation: nothing happened. Eventually, though, the rise in energy prices led the ECB to act, raising its key repo rate by 0.25 percentage points towards the end of the year. The ECB was quick to emphasise, though, that markets would be wrong to think that the ECB was about to mimic the Federal Reserve's behaviour: European rates might be rising but there is apparently no desire to push rates up by 0.25 percentage points at each and every policy meeting over coming months.

Perhaps the best way to think about these monetary adjustments is in terms of insurance. Central bankers are fully aware that inflationary behaviour appears to have morphed in recent years. Their econometric models may be telling them that inflation is on the verge of re-accelerating, but the reality is a lot more encouraging: in the absence of a rise in labour costs, it's difficult to see why we're about to embark on a new era of high inflation. So there are two justifications for raising interest rates now. First, the danger remains that wage costs will eventually re-accelerate, so better to pre-empt that risk by firing a monetary shot across the wage-negotiating bows. Second, there's always the possibility that energy prices will keep on going up as China, India and other developing countries continue to enjoy rapid rates of economic expansion. Central bankers tend to focus on so-called "core" rates of inflation, which exclude energy prices, but if energy prices are persistently rising it makes increasing sense to focus on broader measures of inflation that include energy.

The good news, though, is that bond markets hardly shifted during 2005, suggesting that financial markets remain relaxed about inflation. Central banks have a lot of credibility, keeping inflationary expectations under control. And the pressures of globalisation appear to have broken the link between energy price increases and wage rises. So, if there's a lesson from 2005, it's the need to think global. Labour market developments in the West are increasingly dependent on economic developments in the East. Central bank responses in 2006 will depend not just on the results stemming from traditional econometric models but also on the perceived effects of globalisation on both energy prices and labour costs. As for surprises, the really interesting revelations will come not so much from specific events but, rather, from the changing economic relationships that stem from the integration of China, India and other developing countries into the global economy. The pages of the old economic rulebook are becoming increasingly redundant.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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