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No wage relief

No wage relief

Real wages are falling. Next week's official figures are expected to show that consumer prices inflation has risen a little more, to around 2.4 per cent, while wage growth is stuck below 2 per cent. You might think this is good news for investors, as it suggests workers rather than companies are bearing the cost of the rise in import prices caused by sterling's fall. Such a view, though, might well be too complacent.

To see why, just remember the circular flow of income. What companies in aggregate pay out in wages they often get back in the form of consumer spending. The level of wages in itself does not raise or lower aggregate profits. What matters instead is the gap between wages and spending. High wages can be good for profits if workers spend them - this is the theory of wage-led growth - but not if they don't.

And herein lies the problem: a squeeze on real wages might be accompanied by an even sharper slowdown in consumer spending. If so, aggregate domestic profits will be squeezed. I say so for two reasons.

One is that it's possible that consumers pulled forward spending they would have done this year into last year in an effort to beat the price rises that sterling's fall will cause.

Another is that higher inflation has in the past often been accompanied by a rising savings ratio; one reason for this is that inflation cuts our real wealth by reducing the purchasing power of non-interest bearing money, and we save more to rebuild our real wealth.

These two theories are consistent with a big fact - that retail sales volumes have fallen recently. Official figures show that they were 1.5 per cent lower in February than they were in October.

You might add that there's a third reason to expect consumer spending to be even weaker than wages this year. Figures last week showed that households' savings ratio has fallen to a record-low, and that net borrowing (roughly speaking, the gap between savings and the amount spent on buying houses) has hit an all-time high. This poses the danger that both are unsustainable. If so, spending will have to fall relative to incomes.

How great is this threat? Three things suggest: not much. One is that banks are willing to extend credit. Although next week's survey from the Bank of England might show a slight tightening in credit availability, this will follow years of loosening standards.

A second is that employment is high and rising. While this remains the case, households will be able to service their debts.

And thirdly, common sense tells us that people should run down their savings or borrow more to sustain spending if they think a cut in their incomes will be only temporary.

The truth is, though, that we're in the dark here. Aggregate data don't tell us what level of debt is sustainable. Much depends on the distribution of debt and the distribution of shocks: if highly indebted folk suffer bad news about their incomes, they'll have to retrench. But if the bad news is small, or falls more upon financially stronger households, spending will hold up.

It would be rash to forecast a disastrous retrenchment - although the risk is there. What's perfectly possible, though, is that spending does weaken a little relative to wages. And this would inflict damage on the profits of domestic consumer-oriented stocks.

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By Chris Dillow,
04 April 2017

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Chris Dillow

Chris spent eight years as an economist with one of Japan's largest banks. Here, he provides insightful commentary on the latest economic news and data, along with thought-provoking articles about investor behaviour.

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