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The author, an adviser to Allianz and Gramercy, is the president of Queens’ College, Cambridge.
The blame for the UK’s inflation problem, which is causing mortgage difficulties and reducing purchasing power, is increasingly being placed on excessive wage increases. While recent wage data and inflation warnings from the UK chancellor and the Bank of England have reinforced this narrative, it oversimplifies the issue and can be misleading. Additionally, it heightens the risk of economic stagnation, exacerbating the current inflation and interest rate challenges.
The current phase of high UK inflation is reminiscent of the experience of advanced countries in the 1970s and 1980s. Initially driven by a few factors (such as energy and food prices in this case), it leads to widespread price increases across various sectors before affecting services. As a result, inflation does not rapidly decline even after the initial shock subsides. Moreover, this process both drives and is fueled by wage growth, which is less responsive to interest rate hikes.
According to the latest data, wage growth for the three-month period ending in May reached 7.3%, surpassing the projected 7%. Pay in the private sector increased by 7.7%, outpacing the public sector’s 5.8%. These figures prompted market interest rates to rise, and mortgage providers raised the average two-year mortgage rate to over 6.6%, the highest level in 15 years.
Both Chancellor Jeremy Hunt and Bank of England Governor Andrew Bailey reiterated the need for wage restraints at the Mansion House gathering of finance industry representatives. Bailey also indicated the possibility of a second consecutive 0.5 percentage point interest rate hike at the upcoming meeting of the Bank’s Monetary Policy Committee.
Debates on UK inflation now primarily revolve around wage-push inflation, where providers of goods and services pass on higher labor costs to consumers. This is unfortunate for three reasons.
Firstly, it occurs at a time when real wages have already significantly declined due to a peak in inflation above 10%. Even the recent wage increase, although substantial in nominal terms, falls short of May’s consumer price inflation of 8.7%.
Secondly, the drivers of inflation are more intricate and diverse than just wages. They include central banks’ initially timid response to what they perceived as “transitory” inflation, disrupted international supply chains, a tight labor market, and companies prioritizing profit margin maintenance.
Thirdly, focusing excessively on wage restraint as the primary solution to reducing inflation increases the likelihood of a recession. It would further weaken household demand at a time when high mortgage costs already burden households. Additionally, economic activity and the provision of essential public services are susceptible to labor strikes.
Although it may be tempting to view these issues as uniquely British, with inflation running at more than double the US level and above that in the eurozone, and wages increasing at a faster rate, the services sector’s strength in all three economic regions presents a significant risk. There is a possibility that the US and the eurozone may eventually adopt a similar approach to framing the challenge and solution to inflation, further hindering global growth, already impeded by China’s disappointing economic recovery.
The UK should take the lead in implementing a comprehensive policy response. This approach should complement interest rate hikes and wage restraints with meaningful measures to stimulate the supply side. It should leverage the necessary energy transition, embrace exciting technological innovations, and reevaluate the most effective path for achieving low and stable inflation.
Such an approach would not only reduce the risk of stagflation but also enhance prospects for sustainable productivity growth and expand the country’s growth potential. It would provide a better opportunity to address long-term challenges posed by climate change, high debt, low growth, and excessive income, wealth, and opportunity inequality.
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