Dr Gerard Lyons is a senior fellow at Policy Exchange. He was Chief Economic Adviser to Boris Johnson during his second term as Mayor of London.
The cost of living crisis is central to the current economic and political debate. At its core is the rampant pace of inflation. It has also exposed sluggish wage growth, which is not keeping pace with it.
This is a common problem across western economies. Inflation has contributed to the difficult backdrop for financial markets in recent months. As global inflation rose, markets expected higher policy rates and penalised countries like the UK that were seen as being behind the curve in tackling it.
But the global picture is now changing across financial markets. Worries about inflation have been superseded by concerns about an economic slowdown.
Jerome Powell, Chairman of the US Federal Reserve has communicated well – so markets still expect interest rates globally to head higher to keep inflation in check.
But central banks are expected to be less aggressive in terms of the speed or scale of tightening than once feared. Indeed, UK policy rates are expected to peak around 4.5 per cent next summer.
The challenge, though, is that history suggests that it usually requires a sustained monetary policy tightening to keep inflation in check.
The UK’s annual rate of consumer price inflation (CPI) reached 11.1 per cent in October. Core CPI, which excludes fuel, food, drink and tobacco is up by 6.5 per cent.
There have been two main drivers of our inflation: supply side pressures and poor monetary policy.
The supply side pressures were a legacy of bottlenecks in supply chains owing to the pandemic and high energy prices because of the war in Ukraine. Now, global transportation costs have eased considerably and oil prices are well off their peak.
As the Office for National Statistics (ONS) reports, in October “households are paying, on average, 88.9 per cent more for their electricity, gas and other fields than they were paying a year ago.”
In its November Monetary Policy Report, the Bank of England expected inflation to decelerate sharply from the middle of next year, and to be back below the two per cent inflation target in two years, and even further below it in three years.
While inflation will decelerate, we can not be sure where it may settle. It could undershoot the target in 2024 but, even if it does, when inflation settles post this crisis, it may be more around three per cent to four per cent, higher than the two per cent pre-pandemic level we were used to.
During the early 1990s, I was one of a small group of economists who correctly felt that the changing macro-environment meant that the UK was then moving to a new phase of low inflation, away from the relatively high inflation of seven to eight per cent witnessed at the start of that decade. One lesson from then relevant for now is that expectations were slow to accept the new landscape, expecting inflation to return to where it had been previously.
This might be a worry now as the expectation is that inflation will return to the two per cent inflation target. But there is no guarantee it will.
Remarkably, there is little criticism of the poor judgement of the Bank of England in allowing inflation to take hold.
The common retort about the Bank’s action is that “in hindsight” a tighter monetary policy would have been preferable as if it wasn’t obvious at the time, but even then “it would have only reduced current headline inflation by one per cent”.
But what this common analysis misses is that if the Bank had tightened policy last year when the economy could have coped, not only would inflation be less, but any hiking now would cause less pain to the economy. Also, hiking earlier would have given the market greater confidence that the UK could deal with inflation, instead of it being behind the curve. This partly helped feed the febrile state of financial markets in recent months.
There also seems to be limited awareness of how excessive QE and low interest rates helped create a fertile environment for inflation to take hold. Meryvn King, the former Governor of the Bank, has correctly highlighted this.
Early last year, I asked on this site which “p” would inflation be? Pass through quickly, persist or be permanent. I said it would “persist”, at the time the Bank wrongly thought it would be “transitory”. To become permanent, there would have to be a significant shift in the factors contributing to low inflation. Two factors that contributed to low inflation may now be changing: globalisation and the declining wage share.
We are not seeing a reversal of globalisation. But on-shoring and friends-shoring is more widely talked about, so keeping costs down is not the only driver behind supply chain decisions now.
But what about wages? ONS annual data shows that since 2016 the share of wages has risen from low levels.
The nature of our inflation shock means a domestic overheating economy is not to blame. Indeed domestic demand is sluggish. That not only allows scope for targeted fiscal measures, but it means that wage demands have not been the driver of inflation despite a tight labour market.
It is necessary to be mindful of second-round effects that could see higher inflation become embedded. These include a wage-price spiral, where higher wages force prices up and add to wage demands. Or a cost-push spiral where higher costs lead firms to raise prices, to maintain or boost profit margins.
What then of wages? In the Autumn Statement, an increase in the minimum wage was announced, from £9.50 to £10.42 next April. This is statutory. In September, meanwhile, the Living Wage Foundation raised their real living wage to £10.90 and to £11.95 in London – with the firms embracing this doing so voluntarily.
While welcome, one has to be mindful of the cost pressures on many small firms who do not enjoy the luxury of being able to pay higher wages easily and who are being hit rising energy prices and by higher taxes. It is important not to lose sight of the role taxes play in the cost of living debate.
While it is important to prevent a wage-price spiral, in the rail dispute there is a case for the Government to help broker a deal – especially for low paid workers, but also alongside sensible reforms.
Reforms, too, should be central to the debate about public sector pay. As Robert Colville pointed out in an insightful column in the Sunday Times last year, pay in the health system is not based on ensuring people are paid competitively in the areas where there are shortages, but determined by a complex matrix structure that as he described “suits the unions”.
The system is inflexible, and so rewarding, incentivising or recruiting staff in areas of pressing need is hard.
In my view, the result is that front line staff like doctors and nurses in competitive areas are underpaid, relative to what they should receive, and a whole host of people working in areas where there are no shortages are well paid.
So when one drills down into the low wage issue it highlights broader policy areas that are all too often overlooked but are solvable.
Additionally, the UK has consistently under invested in skills and training, often opting to close shortfalls through immigration.
Higher inflation has led to higher wage demands, and these have drawn attention to a host of issues like the need for reform and more investment in skills and training. In a competitive economy though, neither private sector firms nor the public sector can keep paying higher wages unless justified by higher productivity. Lowering inflation is just the first step.