Labour market holds key to inflation riddle
Monday 07 August 1995
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.
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