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OPINION

Elusive wage inflation

Elusive wage inflation
June 29, 2017
Elusive wage inflation

Back in 1958, that hero, Bill Phillips, pointed out that there was an inverse relationship between unemployment and wage inflation, with lower unemployment leading to higher wage growth; this is the famous Phillips curve. If this relationship still holds, there's an obvious case for raising interest rates. The unemployment rate is now lower than at any time since 1975, which should trigger rising wage inflation and hence higher price inflation. If the Bank of England is to keep inflation at its 2 per cent target, interest rates will therefore have to rise.

Of course, the official unemployment rate is an imperfect measure. But fancier estimates tell the same story. The OBR has estimated that the economy was operating above full capacity at the end of last year, and the Bank of England believes that "spare capacity is being eroded". That's why three MPC members - Kristin Forbes, Ian McCafferty and Michael Saunders - recently voted to raise rates.

But there's a problem here; there's barely a flicker of wage inflation. In fact, in the past three months, this has been lower than it was in much of 2011 when unemployment was over 8 per cent. The Phillips curve has been flat (as, in truth, it was in some of Mr Phillips' data). This is part of a broader phenomenon - the fact that core inflation has been remarkably stable since around 2000, despite huge swings in exchange rates, oil prices and monetary growth and despite the financial crisis. "The striking property of inflation of the past 20 years has been its complete invariance to shocks and policy changes," says Eric Lonergan of M&G. "Inflation is truly dead, and policymakers don't need to worry about it."

It looks as though a given level of unemployment is now associated with workers having less bargaining power than before. One reason for this might be that workers have been scared by the 2008-09 recession into accepting low wage settlements - just as memories of the 1930s depression scared workers in the 1950s. In a speech last week, Andy Haldane, the Bank's chief economist, gave some other reasons. Labour markets, he says, have become more "divisible": the gig economy, individualised wage bargaining and fragmentation of tasks have all reduced workers' power.

To the extent that these developments are long-lasting and dominant, inflation should fall back once the effect of higher import prices has passed through. Interest rates don't therefore need to rise much.

This isn't to say they won't rise at all. There might be, as Mr Haldane says, a case for withdrawing last year's cut, which was insurance against a sharp economic slowdown which has not (so far) materialised. And with productivity stagnating, even moderate wage growth implies rising unit wage costs and hence above-target inflation.

The point is, though, that what happens to interest rates isn't a narrow financial matter. It depends on the extent to which deep cultural and structural forces are transforming the lives of working people - and not for the better.