Wednesday, February 16, 2011

Inflation and Pay Deals

In previous posts, I mentioned how the MPC faces a difficult period - essentially the conflict between sluggish recovery combined with high inflation.

It may start to sound a bit repetitive, but the inflation we are experiencing is essentially due to cost push factors (higher oil costs, raw material prices). This is leading to a rise in producer prices and CPI (rose to 4%), but underlying factors and measures of 'core inflation' still remain muted - though is starting to edge up.

Of great significance is the impact of higher CPI inflation on wage growth and inflation expectations.

Source: ONS | Real wages in UK

Evidence suggests that nominal wages are not keeping pace with CPI inflation. This strengthens the argument that the 4% inflation we are experiencing is temporary and is not leading to an increase in underlying inflation. The fact real wages are falling shows unions have little power in a climate of high unemployment, spare capacity and prospect of more job losses.

The MPC will be aware that if temporary inflation persists long enough, it can start to cause a rise in inflation expectations and a rise in underlying 'core' inflation. (see: does temporary inflation cause underlying inflation)

Despite all the complications of higher inflation, lower living standards and uncertain recovery, the MPC are doing the right thing in delaying interest rate increases. This will come as little comfort for those seeing a decline in the real value of their savings or workers who are experiencing a decline in living standards, but we face a testing situation where we will have to accept a worse trade off - at least in the short term.

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