Why inflation fears are overblown and misplaced

Wage rises and mild inflation, after decades of stagnant real pay and deflationary pressure, would be no bad thing.

Bank of England chief economist Andy Haldane has added his voice to the growing chorus of warnings about the imminent threat of inflation. Citing the risk of what he called a “wagey-pricey” spiral as demand recovers from the first Covid-19 shock, Haldane and inflation hawks such as former US Treasury secretary Lawrence Summers have been quick to suggest that current levels of government spending across the globe will need to be rolled back, and the “loose money” policy of vast quantitative easing (QE) and low interest rates curtailed. Haldane, who will leave his role at the bank later this month, believes the wagey-pricey spiral would be a feeble descendant of the fabled 1970s “wage-price” spiral, in which rising prices set off demands for higher wages, in turn pushing up prices, and so on.

These aren’t the first inflation warnings from central banks or those connected to them. The Bank of International Settlements, the “central banks’ central bank”, was already flagging inflation risks in its 2020 Annual Review, published last summer at the height of the first wave of Covid-19. “[P]eering into the future”, it suggested that something like the economic situation in the postwar West could re-emerge as a result of the pandemic, with permanently larger government, globalisation “forced into a major retreat”, and “labour and firms” much more able to set their own prices as a result. Much like the period after the Second World War, we would expect somewhat higher inflation – but also, crucially, higher wages.

Some of this may already be taking place. Trade became a less important part of the global economy in the decade after the 2008 crash, and of course the pandemic has hammered international trade in services such as tourism and aviation. Governments across the world were already becoming more active in the economy after 2008, increasing their spending relative to GDP and returning to forms of industrial strategy. Covid-19 appears to have accelerated both tendencies, and the pre-Covid world will not entirely return. The UK’s Office for Budget Responsibility, for example, forecasts government spending as a share of GDP to be the highest since the early 1980s even after all exceptional Covid-related spending has been wound back.

But as I have argued before, the impact of the virus seems likely to increase the costs and difficulties of employing labour over the longer term. And these extra costs and difficulties create the potential for labour’s bargaining position to be improved. If, for example, labour can be withdrawn more easily because of health risks and employers lose some of their control over the terms and conditions of work because of the need for various forms of protection at work then, other things being equal, labour will be in a stronger position.

As retail opens up and people go out to spend, we are already seeing how restaurants and pubs, facing restricted labour supplies, are offering higher wages. Demands for protection at work have sparked strikes, and union membership in Britain last year rose at its fastest rate since the late 1970s. If, as the epidemiologists predict, Covid remains a risk for the foreseeable future, those restrictions on labour supply will not be fully removed: some extra costs and difficulties will remain. There is likely to be significant churn in the labour market, with McKinsey forecasting 2.7 million “job transitions” over the next decade, as employers seek to reduce their use of labour in sectors such as retail, primarily through automation. But because the possibilities of automation are so sector-specific, it won’t necessarily translate into a generalised weakening of labour in the way that mass unemployment usually does.

Coupled with “the great demographic reversal” identified by Charles Goodhart and Manoj Pradhan in their recent book, with the future global labour supply growing far more slowly than over the last 40 years, the stage is set for the balance of the economy to tilt towards those who work. Wage rises, after decades of stagnant real pay in the developed world, would be no bad thing. Mild inflation, below the increase in money wages, and happening after decades of deflationary pressure, would also be no bad thing.

But rising inflation wouldn’t result from an excess of money in the economy, and nor would it come about because a government is “overspending”. Increased inflation would be the product not of monetary factors, but real ones in the first instance – such as longer-term increases in labour costs – making taxes and subsidies more effective price-control mechanisms. The worst possible government response to this changed environment would be for central banks to tighten monetary policy – reversing QE and raising interest rates – and for government to impose deep spending cuts.

If inflation is reappearing as a result of longer-term increases in costs, rather than increases in the effective money supply, monetary policy can do little to affect it – and tighter money risks driving hugely indebted firms and households into bankruptcy as interest rates rise and loans cannot be rolled over. Meanwhile, if government spending has to be raised as a result of rising costs, for instance to fund the longer-term burden Covid will impose on healthcare systems, cutting spending will damage public services while (as we have seen with a decade of austerity) redistributing resources in exactly the wrong direction – up the income scale. The only way either strategy plausibly influences inflation is by weakening the capacity of those who work to bargain for higher wages.

Productivity growth could ease the tension by creating more space for pay increases without squeezing profits, but productivity has been stagnant in the developed world for a decade, with few signs of recovery pre-pandemic. Demands for tighter money and cuts to spending should instead be seen for what they are: a pre-emptive strike against labour.