Asking for a pay rise won't crash Britain's economy

16 June 2022

11:27 PM

16 June 2022

11:27 PM

The Bank of England has just raised interest rates for the fifth time in the row, warning that inflation is expected to pass 11 per cent by the end of this year. If it had escaped your notice, everything is getting more expensive, and the government is powerless to help. The extent of the Bank’s assistance has been to tell you not to ask for a payrise. Boris Johnson, meanwhile, seems furious that taxes are so high, and will be having stern words with whoever raised them. Even Freddo bars aren’t exempt from the cost of living crisis, shooting up to a frankly outrageous 30p each.

Inflation is essentially a problem of too much money chasing too few goods. Markets don’t like unmet demand, or unused supply. If people are lining up to buy goods that are selling out, prices rise until supply and demand match. This is exactly what’s happening now, with an unusual twist: rather than overheated demand, goods are selling out because production is low. If supply contracts while aggregate demand is high, prices rise until both are balanced.

This puts the government in a difficult position. Supply is down because of global events it has little control over. The first is the Covid-19 pandemic, which has fouled up global supply chains from factories to shipping. As households return to normal and begin to spend, demand has risen. Production and logistics haven’t been able to keep up. Last winter’s scenes of ships queuing off the coast of America waiting to offload goods at bottlenecked ports were an obvious sign that something was badly wrong, and shipping isn’t expected to return to normal any time soon. Away from the freight side, lockdowns in China are playing havoc with production schedules, and labour absence across the West remains an issue. These effects meant inflation was already up to 4.6 per cent by November last year.

The second shock to the system came in Ukraine with Russia’s invasion. Between the conflict and sanctions, prices for oil, gas, and raw materials have shot up. Even though Britain imports relatively little energy from Russia directly, it still feels the pinch: it’s now competing with much higher demand for the suppliers it buys from. It’s no surprise that energy prices are a major contributor to today’s inflation. In the Eurozone, energy prices have shot up 39 per cent year on year.

The response to these shocks explain partly why inflation differs so much across countries. Even in the Eurozone where countries share a single currency, inflation can be as low as 5.8 per cent in France to 20.1 per cent in Estonia; the extent of dependence on Russian energy and ease of switching supply is a major driver. If you’re lucky enough to be Switzerland, where gas and oil only make up one per cent of your electricity supply, then energy prices basically haven’t risen at all. Combine that with your own currency and central bank, and inflation sits at just 2.4 per cent. There are, of course, other domestic factors that make a difference. Brexit may turn out to have long term benefits, but right now it’s driving prices up as we reorient our economy away from Europe and adjust to the new barriers to trade.

So that’s the bad news. Inflation is high because supply is down, and supply is down because of factors we can’t control. With that said, here’s a little encouragement: you can safely ask for all the pay rises you want. It’s not going to crash the economy. What Boris and the Bank say they’re worried about is a so-called ‘wage-price spiral’, where demands for higher wages push up production costs, which feed into rising prices and start the whole cycle over again.

This shouldn’t worry you. Britain’s labour market is highly flexible, and wages are rarely the result of unionised bargaining. This means we don’t have the sort of institutional set-up which gives employees the power to demand wage rises which can push costs up in this way. If wages are rising, it’s because the labour market is running hot. Artificially holding wages down won’t do anything to help with this; when labour is cheap relative to prices, firms keep hiring until demand slacks off or wages rise. The end effect would be to send wages racing the moment wage restraint ends.

This points at one last factor to blame for inflation: the Bank of England. In November, while forecasting rising inflation, the Monetary Policy Committee voted to keep interest rates low, with the market expecting them to hit one per cent by the end of 2022. They’re already at 1.25 per cent. The MPC can’t be blamed for failing to predict Putin’s invasion, or for expecting the supply chain inflation to be a temporary blip. But it is unfortunate that years of low interest rates combined with an increasing emphasis from politicians on growth and employment appear to have undermined confidence in the Bank’s credibility when it comes to tackling inflation.

If people expected steep interest rate increases to keep prices under control, then the very fact of this expectation would help to hold inflation down as companies and households built it into their decisions. Instead, the Bank will have to go the long way around and increase rates higher. This means more economic pain on the horizon.

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