If you wanted to be
optimistic about UK inflation and interest rates, then at first sight
looking at the US might help. Here is inflation in both countries
since the start of 2022.
US inflation peaked
in June last year at 9.1%, and at first its fall from this peak was
slow. By February 2023, eight months after the peak, it had fallen by
only just over 3% to 6.0%. In the UK inflation peaked four months
later than the US, at 11.1% in October 2022. Eight months later, in
June 2023, it had also fallen gradually by around 3% to 7.9%. However
in recent months US inflation has been falling quite rapidly, and in
June it was only 3%. Might UK inflation also begin to fall rapidly?
Are we following the US with a lag of around 4 months?
The way the central
bank has behaved in both countries tells a similar story, with the UK
lagging behind the US in raising rates.
Although inflation
was pretty high at the beginning of 2022, central banks had kept
interest rates low because they expected the increase in inflation to
be temporary and they wanted to protect the recovery from the
pandemic. But from mid-2022 the US Fed increased rates faster than
the Bank of England, and that has helped ensure US inflation is now
falling rapidly. (Quite how much it has helped is another question.)
UK inflation is
indeed expected to fall quite quickly in the UK in the next few
months. The Bank of England’s latest forecast is for inflation to
be below 5% by the last quarter of this year. However if that
suggests to you that interest rates will soon start to come down, you
will be disappointed. Once again a look at the US is instructive.
Despite inflation falling to 3%, the Fed raised interest rates at
their last meeting. The Bank too has said that rates will stay high
for some time. If the inflation outlook is improving, why are rates
staying high?
The answer lies in
the labour market, which in both countries still looks tight. In both
countries wage inflation is still well above what would normally be
regarded as consistent with a 2% inflation target. Here is a
comparison of wage inflation in the UK and US. (For the UK I have
shown a three month rate rather than the usual year on year rate to
better pick up possible turning points, and I have used the Atlanta
Fed Wage Growth tracker for the US. Official
US data on wages shows a similar picture.)
In the US wage
inflation reached a peak in the middle of last year, but falls since
then have been modest. In the UK we cannot be sure that wage
inflation has peaked. In both cases, but particularly in the UK, this
rate of growth in earnings is well above what would be consistent
with 2% inflation. (Something between 3% and 4% would be consistent
with 2% inflation over time.)
As I noted in a
recent
post, you can tell two very different stories about
what is currently happening. In the first story, wage inflation is
high because price inflation has been high, and so once price
inflation starts falling so will wage inflation. In this story, the
inflation problem will be largely self-correcting, and what we are
seeing now is the ‘second round’ effects of a very large but
temporary inflation hike. [1] The second story acknowledges the
temporary inflation hike, but says there is a second problem arising from the pandemic recovery that requires a policy reaction. This
second problem is a tight labour market.
Until the beginning
of last year, central banks believed in the first story. But since
then in both countries the data has suggested a persistently tight
labour market, and it is this that is the main reason why interest
rates have increased. As ever with macroeconomic data, there is a lot
of debate about how reliable any particular labour market indicator
might be (see
this for the US, for example), but the key question is
how tight the market is, rather than is it tight at all.
Where the two
countries differ greatly, however, is in the principle reason why the
labour market is tight, and therefore why wage inflation is high. In
the US it is a story of economic success, with a very strong recovery
from the pandemic. (See the final
chart in this post.) In part this is because fiscal
policy supported the recovery, rather than (in most of Europe) just
supporting the economy during the recession. In contrast the UK has
had a terrible recovery from the pandemic, with GDP per capita still
below pre-pandemic levels. The tight labour market in the UK is the
result of a contraction in labour supply rather than an increase in
labour demand, where causal factors include health problems createdby NHS underfunding and labour shortages as a result of Brexit in
some sectors.
Over the next few
months, therefore, interest rate decisions will focus on what is
happening to wage inflation much more than what is happening to price
inflation. As in the US, in the UK we may find that although price
inflation starts coming down quickly, nominal interest rates will not
start coming down and may even rise. As I emphasised here, what makes
interest setting hard is trying to judge whether you have done enough
when there are considerable lags before higher interest rates have their full impact on activity, and therefore the labour market and wage
inflation. [2]
Perhaps the most
important factor behind the Bank of England’s decision to raise
interest rates last week was this chart, shown at the MPC press
conference.
The solid white area
represents the output of various models of year on year wage growth,
and the white line is the actual data plus the Bank’s forecast for
year on year wage inflation. The models (based on inflation
expectations and various measures of labour market pressure) are
suggesting wage inflation should have started falling this year, but
the actual data hasn’t. The Bank’s/MPC’s reaction is to assume
that wage inflation will continue to be above the models’
predictions, and as a result to tighten policy. [3]
What is clear is
that the UK is entering a new phase of this inflationary period
(which the US has been in for several months), where the focus shifts
from energy and food prices and large cuts in real incomes to the
labour market and positive real wage growth. [4] In the UK average private sector wage inflation has almost caught up with price inflation. The key issue now
becomes whether, as price inflation falls, wage inflation will also
do so, allowing interest rates to stop increasing and start falling.
[1] You could call
this a price-wage spiral, but I wouldn’t. ‘Spiral’ is one of
those
words often used in the 1970s that implies an
explosive process, whereas today is a very different world. The idea
behind the first story about current inflation is for periods where either price or wage inflation lead the other, but both naturally decrease over time.
[2] A lot of popular
discussion about inflation on the left focuses on profits rather than
wages. As I have argued before, there was a case for stronger
windfall profits on energy producers, and there remains a very strong
case for windfall profits on banks to offset the gains they are
making on holding reserves. However, none of this can avoid the fact
that wage inflation running at current levels in most of the private
sector is inconsistent with achieving the inflation target, which is
why interest rates have increased so much over the past year and a
half.
[3] There are a
whole host of reasons why wage inflation in the UK might be higher than
most models would predict, including data errors or backward rather
than forward looking inflation expectations.
[4] Food inflation
is still high however, and this will particularly impact those with
lower incomes, some of whom may experience further falls in their
real incomes.
[5] Because US
growth is much healthier than in the UK, as well as other reasons,
real wages have been rising for a year in the US.
