Wage inflation is the key to whether there is a rise in UK interest rates this year. As the Governor said in his open
letter to the Chancellor following the rise in annual CPI inflation to 3.3% in May “it is crucial that prices other than
those of commodities, energy and imports do not start rising at a faster rate”.
Wage inflation is key to whether UK raises base rates
Wage inflation is the key to whether there is a rise in UK interest rates this year. As the Governor said in his open letter to the Chancellor following the rise in annual CPI inflation to 3.3% in May “it is crucial that prices other than those of commodities, energy and imports do not start rising at a faster rate”. What this means was made much clearer in the minutes of the June MPC meeting at which base rates were kept at 5% by an 8:1 majority, with the dissenter, Danny Blanchflower, voting for an immediate cut of 0.25%.
The MPC said in the June minutes “There was also a risk that, given the likely squeeze on real income growth as a result of the changing relative prices for energy, food and imports, employees could respond by raising wage demands. Although wage growth had remained moderate in recent months, surveys indicated that higher
inflation had already had an impact on the public’s expectations of inflation, at least in the near term. As such, the Committee continued to judge that a slowdown in activity, reducing pressure on supply capacity and helping to contain wage growth, would be necessary to ensure inflation returned to the 2% target”. The argument for an
immediate rise was dismissed on the grounds that medium-term inflation expectations still remained well anchored and that credit constraints and higher yields were dampening demand. In short, a slowdown in growth was required to help to bring inflation back down to the 2% target in two years and rates would only be raised if the slowdown was not sufficient to slow the rise in inflation. Interest rates would not be cut just because a slowdown in economic growth was taking place.
Are inflation expectations anchored?
Taken collectively, the MPC seems to think inflation expectations are anchored, saying in the June minutes that “Some comfort could be taken from the relative stability of nominal forward interest rates from five to ten years ahead. If markets had expected that inflation would persist at high levels, then these rates would most probably
have risen". However, we would argue that inflation expectations have risen, as chart a shows. Using breakeven inflation rates (nominal 10 year bond yields minus index linked), inflation expectations are the highest they have been since the MPC was set up in 1997 (Although issues surrounding demand and supply of index-linked bonds
may be clouding the signal). Worse, if consumer inflation expectations are taken into account, as they should be, they are the highest since the BoE’s own survey started in 1999. In fact, the MPC seems to accept this point in the minutes, which noted that: “inflation would have some tendency to persist above the target if those making
decisions about wages and prices began to expect higher inflation in the future”. So the battle against anchoring inflation expectations has already been lost though it could possibly be regained without too much damage so long as actual inflation falls back quite quickly. This puts even more pressure on the MPC to ensure that wage
inflation does not rise and that the pace of economic growth slows down as predicted in the May Inflation Report.
How well behaved is wage inflation?
Wage inflation in the UK is clearly very low. Chart b shows that wage inflation has not responded to the rise in retail price inflation and this has resulted in a historically wide gap between the two that will squeeze real incomes and so weaken consumer spending and undoubtedly economic growth. Moreover, chart c shows that the UK labour market has been very flexible in the last few years, with wage inflation falling as the economy weakens. This is good news for price inflation as it implies that, as economic growth slows, so too will wage inflation or least it is likely to stay low and not rise as much as it would in the absence of this link. But the reason why wage inflation may have remained well behaved was that inflation expectations were low (they are high at present) and consumer price inflation was not as high as it is currently. Further, price inflation is likely to climb further before subsiding,
putting even greater pressure on wages to respond. In addition, UK employment has risen to its highest level on record in the last two years, and unemployment is at the lowest level seen in 30 years, despite some modest rise in the latter in recent months.
Wage inflation to rise further but in 2009, triggering rate rise at that time
We have put together an equation based on retail price inflation, unemployment and employment growth, to estimate what the rate of wage inflation should be given these trends. This is shown in chart d. It confirms our suspicion, which is that rising price inflation at a time of high employment and falling unemployment would normally have led to a much stronger rise in wage inflation than we are currently seeing. This therefore highlights the need for economic growth to slow, so that wage pressure eases. It also highlights the risks from inflation expectations becoming unanchored, as this will make workers much more unwilling to accept low wage increases
relative to price inflation. This pressure became intense last year, as retail price inflation hit a peak of 5%. So the MPC is right to warn that a slowdown in growth is necessary to keep wage inflation down. The risk is that wage inflation approaches 6% before it responds to weakening economic growth. This is what our model suggests will happen by the end of 2009, but we do assume at least 1 rise in base rates, to 5.25% in the first half of 2009. The risk is that this will not be enough and the MPC may have to do more, to ensure that growth slows and wage inflation falls back from what may be a peak of over 5%.
It is noteworthy that the debate about UK interest rates has moved on dramatically from just two months ago, when the prevailing view was that rates would be cut. Why the change? The reason is that the credit crisis, though important, has proved less destructive for economic growth than feared, and price inflation has accelerated
sharply, driven by rising global commodity prices. Our view was and is that inflation is more of a threat to the UK and global economy than the credit crisis. Hence, action should be taken to keep price inflation low and stable, even if that means raising rates with the credit crisis unresolved so long as that does not induce recession.
But the risk is that, as the retail sales data suggest, it is already too late and the UK economy may not slow as quickly or as by as much as the MPC thought in May. Although economic growth is slowing, wage inflation must stay low to allow this to help reduce inflation pressure in the domestic economy and prevent any pass through from higher commodity prices to the wider economy through a wage-price spiral. If this fails to happen then the MPC would have little choice but to induce a recession to break a wage-price spiral and re-anchor inflation expectations.
Rate rises are back on the agenda
UK rates are more likely to be raised than not, so expectations of a rate rises are correct in our opinion but the extent of the expected rise seems overdone. Consumer price inflation has accelerated to 3.3% and will go above 4% before retreating, so the pressure for higher rates will remain intense in the months ahead. However, official
interest rates may not rise this year, as growth is slowing and the extent of the downturn is unclear. Moreover, average earnings growth is very low. Data this week are few but should show that the economy is slowing and retailers are gloomy. For the US, the main focus is on gdp, housing and personal spending data. Economic growth is anaemic but consumers have not thrown in the towel, with sales being helped by tax cuts that amount to some 1.2% of gdp, or $170bn. The US Fed is likely to remain on hold though until it is clear that recession is no longer a threat. That may not be until early 2009. In the eurozone, the main data this week are likely to show that activity in the services and manufacturing sector has slowed, but remain well above recession territory. That will cement the case for a rate rise by the ECB at its July meeting.
UK data for house prices and the CBI distributive trades’ survey are out this week, both on Wednesday, and they seem to be tracking each other very well. It appears that consumers are very worried about making a major purchase and are less confident about their economic prospects. Consumer confidence and house prices are indeed very well correlated at present, but house prices are not a great guide to retail spending, as shown by the data last week which revealed that retail sales rose by 3.5% in May alone and was 8.1% up on the year before even though house prices fell
further. And this is despite the very negative outlook for the housing market and gloomy predictions from a number of mortgage banks and commentators. In fact, chart a shows that the current level of sales in the CBI survey is consistent
with annual gdp growth of around 2%. But the UK is also facing a wider trade and current account deficit, because of its strong exchange rate up until a few months ago, and its relative fast pace of growth compared with its major trading partners. However, economic growth is slowing and this will be illustrated by gdp figures for Q1 out on Friday.
In the US, consumer confidence and house prices data are out on Tuesday. They show a close and correlated weakening bias, see chart b. And we expect a weak outcome in the release this week – though house prices falls may persist, consumer confidence could be close to a trough, see data on Friday from the University of Michigan. Alongside falling house prices has been falls in housing sales data this week, Wednesday and Thursday, will show that this trend continues. But there is as little correlation between US consumer confidence and spending as in the UK.
Despite low confidence, US personal spending is likely to rise, boosted by the $170bn of tax cuts due to come through in May. But inflation remains a risk and the Fed cannot cut any further so the next move in Fed fund rates will be up though not until 2009, as the economy is probably still too weak to withstand a rate rise.
The monetary policy situation is much clearer in the eurozone, where the ECB has already signalled clearly that it will raise rates in July. But there are a lot of PMI, and consumer and business confidence surveys due out this week. Activity in services and manufacturing sector is still expanding but consumer and business confidence is slipping. French producer prices, out on Friday, will confirm the extent of the upward pressure from consumer price inflation in the eurozone. At the same time, money supply growth remains high. This is the kind of combination that will justify a rate
hike from the ECB next month.