Earnings blow to hopes on inflation

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The Independent Online
THE BANK of England turned optimistic about the inflation outlook yesterday, just as new figures flashed a warning about dangerously strong pay pressures. An unexpected jump in the growth of average earnings dented hopes that any further increase in interest rates could now be firmly ruled out.

The Bank's latest quarterly Inflation Report was noticeably more upbeat in tone than February's, its central message being that inflation was likely to stay close to its 2.5 per cent target during the next two years.

Yesterday also saw the publication of minutes of April's meeting of the Monetary Policy Committee (MPC), confirming that Charles Goodhart, who had previously voted for a rate increase, had switched sides.

However, Mervyn King, the Bank's deputy governor, warned yesterday that monetary policy remained "finely balanced". A firm hawk on the MPC, his comments on the Inflation Report were tougher in tone than the document itself, suggesting that the committee remains split about its next step.

Mr King said the short-term outlook for inflation was "extraordinarily benign". But he warned, "It is crucial to keep our eyes firmly fixed on the inflation target two years or so ahead", listing several dangers on the horizon.

He drew particular attention to yesterday's figures on unemployment and earnings, and to the potential impact of the minimum wage, due to be introduced next year, on inflation. Its exact level and coverage would determine how much it added to the total wage bill, the Inflation Report warned.

The Prime Minister's official spokesman, asked about this warning, said: "We have been clear throughout the minimum wage [debate that] it will be done in a way that will not do economic damage and indeed will enhance the performance of the British workforce and economy."

Average earnings increased by 4.9 per cent in February, partially fuelled by a 30 per cent increase in bonuses. The rise was well above expectations.

Initial indications suggest earnings growth was even stronger in March - ONS preliminary estimates put the growth rate at 5.4 per cent. Mr King said: "To hit the inflation target those rates of earnings growth will have to fall back".

Some economists emphasised the fact that the bonus payments were a "one- off" factor. Ken Wattret at Paribas added that earnings growth was a "lagging indicator, not a leading indicator".

Nevertheless, the Inflation Report confirmed that pay is one of the more influential economic indicators for the MPC. January's weaker-than expected earnings growth helped tipped the balance towards a no-change verdict at April's MPC meeting.

The ONS originally estimated that average earnings grew by 4.5 per cent in January, a figure that is "only just consistent" with the inflation target, according to the minutes.

Mr King drew attention to growth in manufacturing pay as well as the divergence between public and private sector pay. He added the 3 per cent gap between private and public sector pay was "unsustainable".

A Treasury spokesman agreed, saying private sector pay deals would have to moderate.

April's decline in the number of people claiming unemployment benefit was also greater than many expected. The number on the register fell by 17,700 in April, compared with a drop of 8,300 in March.

The possibility of a steeper fall in the pound than assumed in the forecast posed a second danger for the inflation outlook, according to yesterday's report. "The fall in the exchange rate over the past week has more than offset the rise between the February and May projections," Mr King said.

He added that a further slowdown in domestic demand was also needed. "The Committee will change interest rates in whichever direction is necessary to hit the target."

David Walton, an economist at Goldman Sachs, said: "We could be in for a period of sluggish growth and disappointing inflation," he said

Ciarn Barr at Deutsche Morgan Grenfell agreed: "There was no signal here that interest rates have peaked."

The next meeting of the MPC is on 3-4 June.

Outlook, page 21