Inflation could still come back to plague us

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So far this year the inflation bulls have had it all their own way. Fears that the pound's devaluation would feed through quickly to accelerating prices have been confounded month after month, with the headline rate dropping to a 30-year low.

But we cannot treat inflation like smallpox, as a disease that has been eradicated for good and can safely be forgotten. The long-term vindication of the bull case depends on wage negotiators behaving with uncharacteristic restraint as recovery gathers pace. And long and painful experience should have taught us never to underestimate the British labour market's capacity to disappoint.

Ironically, it has been the unusually benign behaviour of the labour market that has kept inflation low since Black Wednesday. The falling pound raised the cost of industry's raw materials by nearly 9 per cent in the six months after Black Wednesday. But spending on wages and salaries to make each piece of output - two-thirds of companies' costs - fell in parallel, keeping costs constant overall.

The performance of unit labour costs has been spectacular: the fall of nearly 5 per cent in the year to May was the sharpest since records began. Falling unit labour costs reflect high productivity - output per person employed - and low wage settlements. Fewer people have made more goods, and have received smaller pay increases to do so.

Productivity has held up unusually well during this recession. It grew by almost 4 per cent between the second quarter of 1990 and the end of 1992, having fallen by almost the same amount between 1979 and 1980.

Employers shed workers relatively quickly in this recession, in part because early signs of the downturn triggered much greater pessimism among managers than in the early 1980s. The emasculation of the trade unions - especially since the miners' strike of 1984 - has made companies much less nervous about announcing redundancies. Business failures also increased relatively quickly, frightening unions out of strike action and deterring firms from hanging on to under- employed workers in hope of an early upturn. Meanwhile output fell less sharply than in the early 1980s.

But this relatively strong performance may not last much longer. Figures released by the Department of Employment on Friday showed that manufacturing productivity growth in the three months to June was 8.2 per cent up on a year earlier, down from growth of 8.5 per cent a month earlier. May's figure had itself been revised down. The fact that manufacturing employment has risen for two successive quarters while the recovery in factory output has slowed does not suggest that Britain is on the brink of an enduring productivity miracle.

It would not be too surprising if productivity slowed. Business failures have tailed off surprisingly quickly. This should make firms less afraid of hanging on to workers, while falling interest rates have reduced the costs of doing so. Manufacturers are also more confident about rising output.

Unit labour costs have also been depressed because underlying growth in average earnings has plunged decisively below the 7.5 per cent floor of the mid-1980s, reaching a 25-year low of 3.5 per cent in the year to June. Lest this be taken as evidence that wage bargainers have been rendered impotent by the recession, note that earnings have outstripped prices throughout the downturn.

Here again the good news may be coming to an end. The fall in earnings growth this year has been largely the result of the Government's 1.5 per cent limit on public-sector pay increases, a limit which the Treasury has already admitted it will be unable to impose for a second year. Earnings growth in manufacturing, meanwhile, has been stuck at 5 per cent for five months.

Pay settlements too may be bottoming out. Today's pay databank figures from the Confederation of British Industry show that pay settlements averaged 2.3 per cent in the three months to June, slightly higher than in the three months to May and higher still than in the three months to April. The CBI also reports that pay settlements in the service sector have been constant at about 2.9 per cent since the beginning of the year. Figures from Incomes Data Services paint a similar picture.

There are plenty of reasons to expect pay settlements to pick up, especially next year. Most obviously, public sector workers will make up lost ground after their 1.5 per cent limit is lifted. Catching-up has always followed even the most draconian attempts at pay restraint. The Roman emperor Diocletian took the statutory incomes policy to its logical conclusion in AD301 with his Edictum de Maximis Pretiis, fixing wages and executing any trangressors. But even this failed to stick.

Employees may also look with alarm at rising inflation. Even the bulls expect the headline rate to start picking up on Wednesday, with July's figure. The headline rate should jump at the year-end, as the November Budget heralds early increases in excise duties and cuts in mortgage rates drop out of the annual comparison. VAT on fuel alone will add 0.4 per cent to prices in April.

VAT and excise duties put pressure on inflation directly by increasing prices, and workers will naturally try to compensate. But employees' real take-home pay will also be reduced by the National Insurance increase announced in March and any further direct tax increases announced in November. Workers will try to compensate for these as well.

It is important to remember that both interest rate and tax increases - the main tools available to the Government in slowing the economy - fuel wage inflation. In the long run they only depress inflation if they derail economic growth, which itself makes the economy more vulnerable to inflation when growth recovers.

A government that was really serious about reducing inflation in the long term would create room to cut taxes by radically rolling back the frontiers of the state. Despite Michael Portillo's public spending review, it seems unlikely that the Government that created the Department of National Heritage - whose raison d'etre is to subsidise middle class leisure pursuits at the taxpayers' expense - is up to this task.

Workers' willingness to pursue higher pay settlements will depend on conditions in the labour market continuing to improve, and upon company profits being buoyant enough for these settlements to be conceded. July's 200 rise in unemployment does not suggest the downward trend has halted, while revisions to factory employment data now show that manufacturers have been net job creators for two successive quarters.

If, however, unemployment resumes its rise then the bull case on inflation becomes much more convincing. The case is even stronger if the labour market has indeed been transformed during the 1980s, with the effect of Tory employment laws, declining union membership and high short-term unemployment producing a permanent shift in the balance of power between capital and labour. The weight of good news on inflation since the beginning of the year has dramatically improved expectations in the financial markets, as the Bank of England noted last week in its upbeat Quarterly Bulletin. Yields on long-dated gilts had collapsed to a 25-year low of 7.29 per cent when the markets closed on Friday. But the gilts market, and wage negotiators too, are still not convinced that the Government will stick to its inflation target over the next decade. They are wise to be cautious for a while yet.

Gavyn Davies is on holiday.