UK real wages fall will this spark-off inflation?

Real wages fell in the final quarter of 2021, official data shows, thanks to rising inflation. But does this mean inflation will rise further? It depends on inflation expectations, and it depends on technology.

When unemployment is low, inflation rises — or so suggests one of the more famous relationships in economics, the so-called Phillips Curve, which tracks an inverse relationship between unemployment and wage rises.

But the Phillips curve went out of fashion.

It went out of fashion because a new theory came along — the monetarist theory. It suggested that in the long run, there was no trade-off between wage growth (leading to inflation) and unemployment. Instead, went the theory, the trade-off was with ever-rising wage growth. And that becomes a problem because if a growth rate in anything keeps increasing, it eventually goes out of control.

The factor at play here is expectations. Remember, the ideas referred to above grew to prominence in the 1970s, in an era of strong Trade Union influence.

Inflation, expectations and the upwards spiral

The narrative went like this.  When the labour market is strong, unions demand pay rises for workers. This leads to inflation, so unions demand even higher pay rises leading to even higher inflation until eventually, unions start to anticipate inflation. At this point, unions demand pay rises in advance of inflation. This causes inflation to rise even higher, and then unions anticipate that their anticipation of inflation will lead to higher inflation and so on.

And as inflation surged in the 1970s, unemployment began to rise, and we got stagflation — unemployment and inflation, and the Phillips curve began to collapse.

Now, fast forward to today.

The data on wages

According to the Office of National Statistics, weekly earnings (ex bonuses) rose by 3.8 per cent in the three months to November. However, that was roughly one percentage point less than inflation, meaning that real wages fell.

So far, price increases are down to supply shortages, with rising energy costs one of the main drivers. These are one-off factors. Energy prices will not keep going up forever, and there are good reasons to believe that later this decade, as renewables, with their falling costs, take up an ever-higher share of the energy mix, energy costs will fall.

Cost-push inflation is transitory.

The inflation concern

But inflation turns into something more permanent if wages rise in response to rising costs. This is the second stage in the upwards inflation phase.

And since there is a labour shortage, there is a good chance that wages will rise. (This is the Phillips curve again in action, again.)

The next stage is critical. Remember, prices rise due to a mismatch between demand and supply. Let’s say that workers enjoy pay rises, nullifying the effect of inflation, such that despite higher energy costs, demand is unaffected. If that happens, prices may go up even higher.

At this point, we are in danger of entering an upward spiral.

Loose monetary policy during the pandemic may have created the slack in the economy, which can enable this upwards spiral.

Inflation hawks get this sense of deja vu — ‘it is just like the 1970s’, they say.

Except that today instead of trade unions, we have labour shortages which, thanks to retiring baby boomers, are only likely to get worse.

There is one other difference.

Why it is not like the 1970s

The 1970s was a period of inequality, high taxes, poor business dynamism and fairly weak technological advances.

Today it is almost the complete opposite. Inflation hawks typically see parallels with the 1970s and call for less regulation, lower taxes, and less government intervention when in fact, this is precisely what we have been getting these last 40 or so years.

Technology provides the ultimate answer. If ...

• renewables create an energy revolution, and we become less reliant on oil with all the instability that entails, creating lower energy costs
• if robots, 3D printing and super material like graphene, create a productivity revolution in manufacturing
• if software automation revolutionises the productivity of the office
• if hybrid working slashes expenditure on travelling to work or on business attire
• and if autonomous cars revolutionise transport

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If those things happen, the long-term trend will be for lower, not higher, prices.