The recent eruption of industrial action, such as last week’s train strikes, shows how the cost of living crisis is hurting large segments of society. The Bank of England owns and must administer the drug to ensure that the cost of living crisis is brief rather than ongoing.
Contrary to popular belief, the cost of living crisis has nothing to do with low wage growth. Annual wage growth in April was barely 7.0%, more than double the 3.0% average over the past 20 years. And if we ignore the distorted rates during the pandemic, the 4.2% increase in revenues excluding bonus payments is the largest in 14 years.
Instead, it is a result of excessive inflation. May CPI inflation of 9.1% is four and a half times the Bank of England’s 2.0% target. As a result, wages have fallen by 2.2% in real terms over the past year. That’s the biggest drop since March 2012. It means the rapid rise in prices is absorbing all wage increases and forcing households to buy fewer items. So the solution is not to increase wage growth, but to lower inflation.
Unfortunately, households have no influence on inflation. But they can influence their own wage growth. And with the potential pool of replacement workers drying up (the unemployment rate of 3.8% in April is close to its 47-year low), workers have a lot of bargaining power. That is why railway workers, postmen, teachers and lawyers have all recently gone on strike or are considering a strike.
This also seems to work. According to XpertHR, the 4.0% annual wage bill across the economy in May was the largest since September 1992. And some workers, such as railway workers in Liverpool, have recently secured a wage settlement of as much as 7.1%.
However, for the economy as a whole, there is a risk that larger wage increases increase the costs of companies, forcing them to raise their prices even more, forcing workers to demand even larger wage increases. That would be similar in style to the wage-price spiral of the 1970s, when wages and prices drove each other in an upward spiral.
I am not suggesting that people should not seek higher wages or reject raises. That wouldn’t be rational. Instead, it is up to the Bank of England to create a set of conditions that will cause inflation to fall below wage growth. Only then will the cost of living come to an end and households can really benefit from their wages again. A higher interest rate can achieve this in two ways.
First, by weakening the outlook for economic activity, higher interest rates are making companies think twice about raising their selling prices and households think twice about asking for higher wages. Second, higher interest rates show that inflation will be 2.0% going forward, preventing companies from incorporating higher inflation into their budgets.
Of course, higher interest rates will not immediately solve the cost of living crises. In fact, they will add to the pain in the short term by forcing households to pay more to pay off their debts. But the other option of letting inflation rise is less attractive, as it would mean a longer cost of living. Higher interest rates are the lesser of two evils.
If the Bank of England were to raise interest rates fairly quickly from 1.25% now to 3.00%, there is a chance that inflation will again fall below wage growth in the second half of 2023. years, which would be shorter than the six-year decline following the global financial crisis.
The risk is that the bank will not raise interest rates far enough fast enough. That would increase the likelihood that higher inflation will lead to higher wage growth and in turn to higher inflation. Not only would that mean that the cost of living crises last longer, but it would also mean that the Bank would have to bring about a greater weakening of activity in order to reduce inflation. The Bank now has to work hard to protect itself against the risk of a wage-price spiral.
Paul Dales is Chief UK Economist of the independent global research consultancy Capital Economics.