View from City Road: Pay rises in the balance

The fall in pay settlements reported yesterday by the Confederation of British Industry is not as good an omen for inflation as it first appears. Since the three months to April, on which the CBI's figures are based, settlements may well have picked up as falling unemployment encourages more aggressive wage bargaining.

Incomes Data Services, looking at figures for April to July, believes settlements are stabilising and could soon increase. The 4.5 per cent pay increase for 50,000 staff at Marks & Spencer may be a harbinger.

There are good reasons to expect settlements to edge up. Workers may try to compensate for rising headline inflation through the rest of the year, as generous retail discounts disappear and last year's mortgage rate cuts drop out of the annual change in the retail price index. They may also try to pass on the pain of tax increases to their employers, who will have much stronger profits from which to concede pay rises.

The prospect of an upturn in settlements suggests that the annual growth rate of average earnings - currently 4 per cent - will not fall much further and may also soon pick up. It is subject to separate upwards pressures, such as rising overtime, bonuses and drift.

Any rise would be in contrast to the mid-1980s, when earnings growth was stuck around 7.5 per cent for years. But norms were more influential then. Settlements can now fall fast in recession - and rise in recovery.

In the short term, the impact of any earnings speed-up is likely to be camouflaged by high productivity growth as the recovery gets under way.

In the longer term, earnings growth is crucial. If it settles at, say, 5 per cent combined with productivity growth of 2.5 per cent, unit labour costs will tend to grow by 2.5 per cent. This is a fair measure of 'core' home-grown inflation, and would not be bad. The markets, though, are not yet convinced. The inflation rate suggested by the prices of long-term government bonds is still 4 to 5 per cent, which implies a rise in earnings back to 6.5 to 7.5 per cent. Someone is wrong somewhere.