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.

PROMOTED VIDEO
News
Susan Sarandon described David Bowie as
peopleSusan Sarandon reveals more on her David Bowie romance
Sport
Lewis Hamilton walks back to the pit lane with his Mercedes burning in the background
Formula 1
Arts and Entertainment
The new characters were announced yesterday at San Diego Comic Con
comic-con 2014
Sport
Arsenal supporters gather for a recent ‘fan party’ in New Jersey
football
Arts and Entertainment
No Devotion's Geoff Rickly and Stuart Richardson
musicReview: No Devotion, O2 Academy Islington, London
News
i100
Sport
sportDidier Drogba returns to Chelsea on one-year deal
Arts and Entertainment
The Secret Cinema performance of Back to the Future has been cancelled again
film
News
ebookA unique anthology of reporting and analysis of a crucial period of history
News
newsComedy club forced to apologise as maggots eating a dead pigeon fall out of air-conditioning
Life and Style
Balmain's autumn/winter 2014 campaign, shot by Mario Sorrenti and featuring Binx Walton, Cara Delevingne, Jourdan Dunn, Ysaunny Brito, Issa Lish and Kayla Scott
fashionHow Olivier Rousteing is revitalising the house of Balmain
News
i100
Arts and Entertainment
Christian Grey cradles Ana in the Fifty Shades of Grey film
filmFifty Shades of Grey trailer provokes moral outrage in US
News
people
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

Senior Risk Manager - Banking - London - £650

£600 - £650 per day: Orgtel: Conduct Risk Liaison Manager - Banking - London -...

The benefits of being in Recruitment at SThree...

£18000 - £23000 per annum + Comission: SThree: SThree, International Recruitme...

Test Analyst - UAT - Credit Risk

£280 - £300 per day + competitive: Orgtel: Test Analyst, Edinburgh, Credit Ris...

Trainee Recruitment Consultants - Banking & Finance

£20000 - £25000 per annum + OTE £40,000: SThree: SThree Group have been well e...

Day In a Page

Best comedians: How the professionals go about their funny business, from Sarah Millican to Marcus Brigstocke

Best comedians: How the professionals go about their funny business

For all those wanting to know how stand-ups keep standing, here are some of the best moments
Jokes on Hollywood: 'With comedy film audiences shrinking, it’s time to move on'

Jokes on Hollywood

With comedy film audiences shrinking, it’s time to move on
Edinburgh Fringe 2014: The comedy highlights, from Bridget Christie to Jack Dee

Edinburgh Fringe 2014

The comedy highlights, from Bridget Christie to Jack Dee
Evan Davis: The BBC’s wolf in sheep’s clothing to take over at Newsnight

The BBC’s wolf in sheep’s clothing

What will Evan Davis be like on Newsnight?
Finding the names for America’s shame: What happens to the immigrants crossing the US-Mexico border without documents who never make it past the Arizona desert?

Finding the names for America’s shame

The immigrants crossing the US-Mexico border without documents who never make it past the Arizona desert
Inside a church for Born Again Christians: Speaking to God in a Manchester multiplex

Inside a church for Born Again Christians

As Britain's Anglican church struggles to establish its modern identity, one branch of Christianity is booming
Rihanna, Kim Kardashian and me: How Olivier Rousteing is revitalising the house of Balmain

Olivier Rousteing is revitalising the house of Balmain

Parisian couturier Pierre Balmain made his name dressing the mid-century jet set. Today, Olivier Rousteing – heir to the house Pierre built – is celebrating their 21st-century equivalents. The result? Nothing short of Balmania
Cancer, cardiac arrest, HIV and homelessness - and he's only 39

Incredible survival story of David Tovey

Tovey went from cooking for the Queen to rifling through bins for his supper. His is a startling story of endurance against the odds – and of a social safety net failing at every turn
Backhanders, bribery and abuses of power have soared in China as economy surges

Bribery and abuses of power soar in China

The bribery is fuelled by the surge in China's economy but the rules of corruption are subtle and unspoken, finds Evan Osnos, as he learns the dark arts from a master
Commonwealth Games 2014: Highland terriers stole the show at the opening ceremony

Highland terriers steal the show at opening ceremony

Gillian Orr explores why a dog loved by film stars and presidents is finally having its day
German art world rocked as artists use renowned fat sculpture to distil schnapps

Brewing the fat from artwork angers widow of sculptor

Part of Joseph Beuys' 1982 sculpture 'Fettecke' used to distil schnapps
BBC's The Secret History of Our Streets reveals a fascinating window into Britain's past

BBC takes viewers back down memory lane

The Secret History of Our Streets, which returns with three films looking at Scottish streets, is the inverse of Benefits Street - delivering warmth instead of cynicism
Joe, film review: Nicolas Cage delivers an astonishing performance in low budget drama

Nicolas Cage shines in low-budget drama Joe

Cage plays an ex-con in David Gordon Green's independent drama, which has been adapted from a novel by Larry Brown
How to make your own gourmet ice lollies, granitas, slushy cocktails and frozen yoghurt

Make your own ice lollies and frozen yoghurt

Think outside the cool box for this summer's tempting frozen treats
Ford Fiesta is UK's most popular car of all-time, with sales topping 4.1 million since 1976

Fiesta is UK's most popular car of all-time

Sales have topped 4.1 million since 1976. To celebrate this milestone, four Independent writers recall their Fiestas with pride