The Bank of England is likely to say next week that, unless we get a no-deal Brexit, interest rates will have to rise if inflation is to stay on target: this was the message of the last Inflation Report in May. But is the Bank crying wolf?
Recent history suggests so. Twelve months ago, it raised Bank rate and Governor Mark Carney said that with “domestically generated inflation building and the prospect of excess demand emerging”, an “ongoing tightening of monetary policy” would be needed to hold down inflation. Since then, however, rates haven’t risen and yet the latest figures show that consumer price index (CPI) inflation is bang on target at 2 per cent.
Why, then, did the Bank overestimate inflationary pressures? It’s not because they overestimated aggregate demand. Real GDP growth since then has been close to expectations, rising by 1.7 per cent in the 12 months to May against the Bank’s prediction of 1.8 per cent for growth to the second quarter – although consumer spending has been stronger and capital spending and net exports weaker than it forecast.
Instead, the failure lies in the Bank’s assumption that inflation rises when spare capacity (the output gap) disappears. The fact that inflation has stayed low tells us either that there has been more spare capacity than the Bank estimated, or that inflation is less responsive to capacity constraints. This could be because in industries where output is easily scalable, capacity constraints don’t exist: what’s Facebook’s capacity? Or it could be that a more atomised workforce is less able to turn labour shortages into wage growth than in the past. Or it could be that, as companies approach full capacity they devise better production methods to eke out more output.
The latter, though, isn’t happening on a widespread scale. Last week’s figures showed no change in hours worked in the latest three months, implying that productivity rose only slightly in the period and is still lower than a year ago.
It’s here, though, that the inflation risk lies. Wage increases are not being matched by efficiency gains, so unit wage costs are rising a lot – by around 3.5 per cent in the past 12 months. Unless other costs such as raw material prices fall, this means either that profit margins will be squeezed, or that wage growth must fall back, or that inflation will rise. Generations of economics students have been taught that inflation arises from a “battle of the mark-ups”: workers wanting real pay rises versus employers wanting higher margins. If productivity is stagnating, the economic pie isn’t increasing and so this battle is more intense.
Since 2008, the outcome of this battle has been a fall in real wages. With labour shortages now emerging, this might change even if nominal wage growth doesn’t rise much further.
The threat of inflation, then, doesn’t come so much from capacity constraints in themselves as from a lack of productivity growth; there aren’t enough efficiency gains to hold prices down.
Does this justify higher interest rates? Yes, these would suppress inflation by depressing demand and throwing people out of work. But they would do nothing to raise productivity, and could even depress it in the longer run, to the extent that – at the margin – they reduce capital spending. They do not, therefore, solve our fundamental problem.
