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Economics Weekly

Will UK official interest rates be raised this year?

Tue, Jun 24 2008, 06:57 GMT
by Trevor Williams

Lloyds TSB Financial Markets

Wage inflation is key to whether UK raises base rates
Wage inflation is the key to whether there is a rise in UK interest rates this year. As the Governor said in his open letter to the Chancellor following the rise in annual CPI inflation to 3.3% in May “it is crucial that prices other than those of commodities, energy and imports do not start rising at a faster rate”. What this means was made much clearer in the minutes of the June MPC meeting at which base rates were kept at 5% by an 8:1 majority, with the dissenter, David Blanchflower, voting for an immediate cut of 0.25%.

The MPC said in the June minutes “There was also a risk that, given the likely squeeze on real income growth as a result of the changing relative prices for energy, food and imports, employees could respond by raising wage demands. Although wage growth had remained moderate in recent months, surveys indicated that higher inflation had already had an impact on the public’s expectations of inflation, at least in the near term. As such, the Committee continued to judge that a slowdown in activity, reducing pressure on supply capacity and helping to contain wage growth, would be necessary to ensure inflation returned to the 2% target”. The argument for an immediate rise was dismissed on the grounds that medium-term inflation expectations still remained well anchored and that credit constraints and higher yields were dampening demand. In short, a slowdown in growth was required to help to bring inflation back down to the 2% target in two years and rates would only be raised if the slowdown was not sufficient to slow the rise in inflation. Interest rates would not be cut just because a slowdown in economic growth was taking place.

Are inflation expectations anchored?
Taken collectively, the MPC seems to think inflation expectations are anchored, saying in the June minutes that “Some comfort could be taken from the relative stability of nominal forward interest rates from five to ten years ahead. If markets had expected that inflation would persist at high levels, then these rates would most probably have risen". However, we would argue that inflation expectations have risen, as chart a shows. Using breakeven inflation rates (nominal 10 year bond yields minus index linked), inflation expectations are the highest they have been since the MPC was set up in 1997 (Although issues surrounding demand and supply of index-linked bonds may be clouding the signal). Worse, if consumer inflation expectations are taken into account, as they should be, they are the highest since the BoE's own survey started in 1999. In fact, the MPC seems to accept this point in the minutes, which noted that: “inflation would have some tendency to persist above the target if those making decisions about wages and prices began to expect higher inflation in the future”. So the battle against anchoring inflation expectations has already been lost though it could possibly be regained without too much damage so long as actual inflation falls back quite quickly. This puts even more pressure on the MPC to ensure that wage inflation does not rise and that the pace of economic growth slows down as predicted in the May Inflation Report.

How well behaved is wage inflation?
Wage inflation in the UK is clearly very low. Chart b shows that wage inflation has not responded to the rise in retail price inflation and this has resulted in a historically wide gap between the two that will squeeze real incomes and so weaken consumer spending and undoubtedly economic growth. Moreover, chart c shows that the UK labour market has been very flexible in the last few years, with wage inflation falling as the economy weakens. This is good news for price inflation as it implies that, as economic growth slows, so too will wage inflation or least it is likely to stay low and not rise as much as it would in the absence of this link. But the reason why wage inflation may have remained well behaved was that inflation expectations were low (they are high at present) and consumer price inflation was not as high as it is currently. Further, price inflation is likely to climb further before subsiding, putting even greater pressure on wages to respond. In addition, UK employment has risen to its highest level on record in the last two years, and unemployment is at the lowest level seen in 30 years, despite some modest rise in the latter in recent months.

Wage inflation to rise further but in 2009, triggering rate rise at that time
We have put together an equation based on retail price inflation, unemployment and employment growth, to estimate what the rate of wage inflation should be given these trends. This is shown in chart d. It confirms our suspicion, which is that rising price inflation at a time of high employment and falling unemployment would normally have led to a much stronger rise in wage inflation than we are currently seeing. This therefore highlights the need for economic growth to slow, so that wage pressure eases. It also highlights the risks from inflation expectations becoming unanchored, as this will make workers much more unwilling to accept low wage increases relative to price inflation. This pressure became intense last year, as retail price inflation hit a peak of 5%. So the MPC is right to warn that a slowdown in growth is necessary to keep wage inflation down. The risk is that wage inflation approaches 6% before it responds to weakening economic growth. This is what our model suggests will happen by the end of 2009, but we do assume at least 1 rise in base rates, to 5.25% in the first half of 2009. The risk is that this will not be enough and the MPC may have to do more, to ensure that growth slows and wage inflation falls back from what may be a peak of over 5%.

Summary
It is noteworthy that the debate about UK interest rates has moved on dramatically from just two months ago, when the prevailing view was that rates would be cut. Why the change? The reason is that the credit crisis, though important, has proved less destructive for economic growth than feared, and price inflation has accelerated sharply, driven by rising global commodity prices. Our view was and is that inflation is more of a threat to the UK and global economy than the credit crisis. Hence, action should be taken to keep price inflation low and stable, even if that means raising rates with the credit crisis unresolved so long as that does not induce recession.

But the risk is that, as the retail sales data suggest, it is already too late and the UK economy may not slow as quickly or as by as much as the MPC thought in May. Although economic growth is slowing, wage inflation must stay low to allow this to help reduce inflation pressure in the domestic economy and prevent any pass through from higher commodity prices to the wider economy through a wage-price spiral. If this fails to happen then the MPC would have little choice but to induce a recession to break a wage-price spiral and re-anchor inflation expectations.

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