Labour market holds key to inflation riddle

Last week's Inflation Report suggested that, yet again, the Bank of England and Kenneth Clarke, the Chancellor, are at loggerheads over interest rates. Sometimes this is presented as a battle between the responsible, stoutly anti-inflationary Governor, Eddie George, and the soft-on-inflation Chancellor with his eye, not on the economic numbers, but rather on his own backbenchers and ultimately on the voters. Mr Clarke surely is acutely aware of political pressures but his position has strong economic support as well,

The Bank's concern about inflation is easy enough to understand. The underlying inflation rate been creeping up for eight months. The inflation target that the Chancellor (not the Bank) set is an underlying rate in the range 1-2.5 per cent. This was originally set for the end of this Parliament - spring 1997 - but it has been extended forward into the next Parliament. The rate is currently above the upper limit at 2.8 per cent, looks likely to remain there for several months and is forecast by the Bank to be at 3 per cent in the spring of 1997 and at 2.75 per cent, still outside the range, in the summer of 1997.

In these circumstances, it is completely unsurprising that the Bank has continued to press for a rate rise. Indeed, it would be surprising, and in many ways seriously worrying, if it were not doing so. What do we expect the Governor to say: "There are inflationary dangers, but they are probably not very serious and it is worth taking a risk?" No, it is part of the Governor's job to warn about inflation and, quite properly, he has done so. But that does not mean that he is right, nor that Mr Clarke should necessarily take his advice to raise rates.

There are two related issues at stake - one is the forecast itself, and the likelihood of it being right, and the other is the degree of importance attached to hitting the target exactly as specified.

According to one viewpoint, the target is of paramount importance. Credibility is all. If the authorities do not do whatever is necessary to achieve the target then they will pay a heavy price - not only the direct economic losses from higher inflation than the targeted level - but also an increased cost of government finance and weaker sterling.

For anyone who has followed the chequered history of British economic policy over the past 15 years, this policy absolutism will have a familiar ring. It sounds awfully like official attitudes towards sterling M3 targeting in 1979-80. Then, it was supposedly paramount to bring sterling M3 back into the target range: This absolutely must be done... or else. So interest rates had to be raised to unprecedented heights even though the economy was collapsing and the exchange rate was going through the roof. Subsequently, sterling M3 was downgraded and then quietly dumped.

The authorities' next bout of absolutism concerned the exchange rate. It was now supposedly all-important that we keep the pound above its floor of 2.78 to the mark. If not, all hell would break loose; interest rates would rise, inflation would take off. In the event, as we all know, when the pound fell out of the ERM, interest rates and inflation both fell and what broke loose was the economic recovery.

The current policy is different in the sense that the target is now an ultimate objective of policy - namely low inflation - rather than an intermediate target such as money supply or the exchange rate, but the cast of mind is the same. For the policy is not only about the desirability of getting inflation below 2.5 per cent - we can all sign up to that. It is about being prepared to set interest rates at whatever level is necessary, according to the Bank's model, to be sure of getting inflation below 2.5 per cent at a particular, arbitrary point in time regardless of what else seems to be going on simultaneously in the economy, and regardless of the chances of the Bank being wrong.

It is particularly striking that although the Bank's central inflation forecast is above the target maximum, it acknowledges a wide margin (no less than 1.5 per cent) either side of this central view. And according to its own forecasts, the inflation rate is heading back towards the target range.

It would be one thing to adopt an absolute view of the importance of hitting the target at the specified date if we knew that the Bank's forecast of inflation was going to be right. But we don't. On past form, there must be a reasonable chance that it is wrong. HSBC Markets' forecast, shown in the chart, is notably more optimistic than the Bank over the next 18 months. Indeed, we see underlying inflation back inside the target range early next year.

In my view, the labour market holds the key to the inflation riddle. It is the dog that didn't bark - for years now, we have been hearing from the pessimists about the dangers of wage growth picking up substantially. First it was ERM withdrawal, then economic recovery and falling unemployment, then rising headline inflation. Yet the fact is that average earnings growth is still below 4 per cent and pay settlements have not risen at all this year. With growth in earnings at 4 per cent, reasonable productivity growth would give you an inflation rate below 2 per cent. That inflation is currently above these levels is due to the inflationary forces of higher commodity prices and a weak pound. But if the current rate of wage rises is held - and it seems likely to be - then when these inflationary impulses fade out, the annual inflation rate will fall. In fact, the signs are even more hopeful than that because commodity prices have recently been falling.

Of course, it is possible to take a pessimistic attitude to the recent evidence by emphasising Britain's past record. The authorities took a chance with inflation in the late 1980s, and look what happened then. Yet it is difficult to imagine two more different situations for our economy. Then, bank lending was booming, the housing market was rampant, unemployment was falling fast and wage inflation rose from 7.5 per cent in 1986 to a peak of 10.25 per cent in 1990. Although the pound was strong in 1988, the balance of payments was deteriorating fast, indicating that there was suppressed inflationary pressure yet to come out into the open.

Now, although bank lending growth has been rising, it is still moderate. House prices are falling, the rate of fall of unemployment has slowed, wage inflation is stable at less than 4 per cent, and the balance of payments has been improving fast.

This is an uncertain business. The Governor may yet prove to be right about the inflationary threat ahead - but somehow the Bank's position sounds too much like an attempt to compensate for past policy errors. After the inflation of the Lawson boom and the humiliation of Britain's ERM exit, it is perhaps understandable that the Bank should incline towards the masochistic tendency. But this is no reason for Mr Clarke to sign up for membership as well.

Roger Bootle is Chief Economist at HSBC Markets.

Start your day with The Independent, sign up for daily news emails
PROMOTED VIDEO
ebooks
ebooksA year of political gossip, levity and intrigue from the sharpest pen in Westminster
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Selby Jennings: Oil Operations

Highly Competitive: Selby Jennings: Our client, a leading European Oil trading...

The Jenrick Group: Night Shift Operations Manager

£43500 per annum + pension + holidays: The Jenrick Group: Night Shift Operatio...

SThree: Trainee Recruitment Consultant - LONDON

£20000 - £25000 per annum + OTE £40,000 + Car + Pension: SThree: SThree are a ...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + OTE £35K: SThree: We consistently strive to be the...

Day In a Page

Isis in Iraq: Yazidi girls killing themselves to escape rape and imprisonment by militants

'Jilan killed herself in the bathroom. She cut her wrists and hanged herself'

Yazidi girls killing themselves to escape rape and imprisonment
Ed Balls interview: 'If I think about the deficit when I'm playing the piano, it all goes wrong'

Ed Balls interview

'If I think about the deficit when I'm playing the piano, it all goes wrong'
He's behind you, dude!

US stars in UK panto

From David Hasselhoff to Jerry Hall
Grace Dent's Christmas Quiz: What are you – a festive curmudgeon or top of the tree?

Grace Dent's Christmas Quiz

What are you – a festive curmudgeon or top of the tree?
Nasa planning to build cloud cities in airships above Venus

Nasa planning to build cloud cities in airships above Venus

Planet’s surface is inhospitable to humans but 30 miles above it is almost perfect
Surrounded by high-rise flats is a little house filled with Lebanon’s history - clocks, rifles, frogmen’s uniforms and colonial helmets

Clocks, rifles, swords, frogmen’s uniforms

Surrounded by high-rise flats is a little house filled with Lebanon’s history
Return to Gaza: Four months on, the wounds left by Israel's bombardment have not yet healed

Four months after the bombardment, Gaza’s wounds are yet to heal

Kim Sengupta is reunited with a man whose plight mirrors the suffering of the Palestinian people
Gastric surgery: Is it really the answer to the UK's obesity epidemic?

Is gastric surgery really the answer to the UK's obesity epidemic?

Critics argue that it’s crazy to operate on healthy people just to stop them eating
Homeless Veterans appeal: Christmas charity auction Part 2 - now LIVE

Homeless Veterans appeal: Christmas charity auction

Bid on original art, or trips of a lifetime to Africa or the 'Corrie' set, and help Homeless Veterans
Pantomime rings the changes to welcome autistic theatre-goers

Autism-friendly theatre

Pantomime leads the pack in quest to welcome all
The week Hollywood got scared and had to grow up a bit

The week Hollywood got scared and had to grow up a bit

Sony suffered a chorus of disapproval after it withdrew 'The Interview', but it's not too late for it to take a stand, says Joan Smith
From Widow Twankey to Mother Goose, how do the men who play panto dames get themselves ready for the performance of a lifetime?

Panto dames: before and after

From Widow Twankey to Mother Goose, how do the men who play panto dames get themselves ready for the performance of a lifetime?
Thirties murder mystery novel is surprise runaway Christmas hit

Thirties murder mystery novel is surprise runaway Christmas hit

Booksellers say readers are turning away from dark modern thrillers and back to the golden age of crime writing
Anne-Marie Huby: 'Charities deserve the best,' says founder of JustGiving

Anne-Marie Huby: 'Charities deserve the best'

Ten million of us have used the JustGiving website to donate to good causes. Its co-founder says that being dynamic is as important as being kind
The botanist who hunts for giant trees at Kew Gardens

The man who hunts giants

A Kew Gardens botanist has found 25 new large tree species - and he's sure there are more out there