For a government that took office vowing to deliver credibility to the UK’s economic policy framework, 2013 could not be going much worse. The loss of the UK’s AAA status, the preservation of which George Osborne had placed at the heart of his economic plans, has been accompanied by a 7% fall in sterling since the start of the year, leaving it the second-worst performing of the major currencies this year. The news on the economy, meanwhile, has been grim. Data released earlier in the week showed that industrial production posted a 1.2%M/M fall in January, taking it to its lowest level since 1992, while the NIESR estimate of GDP growth pointed to the economy having contracted in the three months to February. This raises the spectre of the UK having entered an unprecedented (in modern times at least) triple-dip recession. Meanwhile, with headline inflation expected to remain firmly above target, sterling on the slide and noises coming from the Treasury and BoE about relaxing the inflation target, inflation expectations have been on the rise. The spectre of stagflation, according to the FT, has returned to haunt the UK.
Economic stagnation certainly looks to be what the UK economy is in store for. As many economists had always suspected, far from unleashing the private sector as the government claimed it would when it launched its deficit reduction strategy, austerity has simply crushed growth. And with the economy having now grown just 0.7% since the government took office, finding a serious economist that believes that the government should not adjust fiscal policy in one shape or another to try and provide more support for growth is becoming increasingly difficult. Unfortunately, there is no sign that the Chancellor, when he presents his Budget next week, is going to take any heed of either the evidence provided by the growth figures or the economists calling for a change in policy. Certainly, if he is planning a volte face, he hasn’t told his boss, the Prime Minister, who last week said that there was no alternative to the austerity drive. Nobody expects next week’s Budget to see a change in economic strategy, leaving the UK’s growth prospects for the coming year almost as poor as over the past year.
But is the inflation part of stagflation really likely? Well, inflation has now been above the BoE’s 2% target since the end of 2009 and the MPC expects inflation to remain above 2% for at least the next two years, in large part thanks to rises in regulated prices. So, in a sense, we already have a mild bout of stagflation. And, of course, the continued fall in sterling will place upward pressure on inflation in the near term. But that will only feed through into permanently higher inflation if it becomes hard wired into the system via higher wage increases. And that seems most unlikely. Even as headline inflation rose above 5% in both 2010 and 2011, wage growth remained firmly anchored around 2%. And wage growth has fallen back even further over recent months meaning ongoing declines in real wages and additional downward pressure on growth. With no sign of any upward pressure on wages, above-target inflation over the next couple of years will continue to dampen household spending, growth and eventually put downward pressure on inflation.
If anything, the medium-term inflation risks in the UK are in the opposite direction. Such weak wage growth, which given expectations of continued very weak GDP growth looks likely to persist, can only prove disinflationary in the medium term. Before the crisis, the MPC had a rule of thumb that 4½% wage growth was broadly consistent with its 2% inflation target, on the assumption of 2½% trend real GDP growth. Even assuming that the UK’s trend growth rate has been permanently lowered post crisis, continued 2% wage growth should be consistent in the medium term with zero inflation, or even lower. Until the UK sees stronger GDP growth and a resultant tightening in labour market conditions, disinflation forces will increasingly dominate.
And there is an even greater fear – that a persistently weak labour market sees wage growth ratchet down continually. The modern UK economy has never seen such a prolonged period of weak growth. We have no idea what the impact of such persistently weak demand will do to wage-setting behaviour. But the lesson from Japan is ominous, where wages eventually started to fall in nominal terms, a key determinant in pushing the Japanese economy into deflation, and keeping it there. The chart below plots Japanese wage growth in the post-bubble period alongside UK wage growth post-January 2007. And the similarity in the evolution of the two series up to now is startling. Of course, there is no reason to believe that the UK labour market will inevitably follow the path taken by Japan during the 1990s – labour market institutions are very different for one. But for as long as the UK labour market sees its adjustment occur via wages as much as employment (the big surprise in the UK has been that unemployment has not risen further), the greater the risk that it does follow Japan down the route of persistently weak wage growth, or even falling wages. It took Japan more than seven years after its bubble burst before it slid into deflation. High inflation in the UK now provides no guarantee that, if an economic recovery and faster wages growth can’t be delivered, the risk of deflation won’t return to haunt policymakers.
Wage growth in post-bubble periods: Japan and the UK
Source: Datastream and Daiwa Capital Markets Europe Ltd.
Grant Lewis, Head of Research