Let’s assume for the sake of argument – and neither man does – that the worst case is actually true and that slowdown in productivity growth will continue. How might this raise inflation?
One mechanism is the conflicting claims theory. Let’s say productivity were to fall so firms are producing less with the same labour force*. This must mean either that workers take a pay cut or that firms’ profit margins fall. But what if workers insist upon getting the same pay? Firms might then try to restore margins by putting up prices. We’ll then get inflation, as a result of a “battle of the mark-ups” with workers trying to protect real wages and firms their profit margins. This is just what happened in the 1970s.
A second mechanism is that if productivity is flat firms can only increase production by hiring more workers. This would increase wages which in turn raises firms’ costs, which they might try to pass onto consumers in the form of higher prices.
There are, however, two reasons to believe that these mechanisms won’t operate.
One is that the increase in labour demand is not causing a rise in real wages. Latest figures show that nominal wages rose only 1.5 per cent in the last 12 months, far below the rate of inflation. Insofar as the labour market is now globalized – and so there’s mass supply of labour – wage growth might stay low.
Secondly, there’s the very fact of an inflation target. If firms believe the Bank will stick to its inflation target, and believe that others believe it will, they will not raise prices, for fear that their rivals will not do so and will thus undercut them. Inflation will then stay low.
And the Bank believes that its inflation target is credible. In a study of inflation options in the latest Quarterly Bulletin, the Bank concludes that whilst uncertainty about inflation has increased, people’s central expectation for it is still “well anchored.”
So, should we stop worrying about productivity? No, for two reasons.
First, low inflation expectations and a credible inflation target cannot be taken for granted. The Bank might have to reinforce its credibility by policy actions. Mr Broadbent warned that if employment does rise, the Bank might tighten policy.
Secondly, even if lower productivity growth doesn’t cause inflation, it has nasty real effects. It means either slower growth in real wages and/or a squeeze on profit margins. And insofar as it betokens slower trend growth in output and profits, it means low equity valuations.
Investors should therefore hope that the fall in productivity is only temporary.
* I’m simplifying here for the sake of exposition. Much the same story holds if productivity growth slows down.
