This inflation fear looks overdone
Apologies if you tried to click on a link in one of our emails yesterday and you ended up somewhere unexpected.
We had some kind of systems update and it sent everything sideways.
It appears to fixed now.
As I say, it gives you a great way to dip a toe into a very exciting – and potentially highly lucrative – area of investing.
Here’s something that made me shake my head this morning.
It’s the Betfair market for next year’s Russian presidential election:
Click on image to enlarge
For those of you more accustomed to seeing traditional fractional odds, you can place a bet on Putin at 1/100 – i.e. a hundred-to-one on.
Granted, the election’s not til next year, so maybe the market will look a bit more competitive by then.
For now, though, “the betting markets” – about which we’ve heard a lot in recent elections (I’ve been guilty of talking about them myself) – are giving a pretty clear verdict.
If they’re wrong again here, it truly will be spectacular.
The rest of today’s DR will be about inflation.
Specifically, should we in Britain be worried that wages will fail to keep up with inflation and act as a drag on the economy?
Personally, I’m not as worried as some. I’ll explain why in a second.
First, a bit of context.
The January inflation numbers came out this morning.
There are still strong signs that higher inflation is “in the post”, as a football commentator might say.
Producer input inflation is running at an annual rate of 20.5%, up from 17% the previous month (and that figure was itself revised higher from an earlier read of 15.8%).
But the headline consumer price number came in a tad lower than expected. Annual inflation was at 1.8% compared to a consensus forecast of 1.9%.
That’s still an increase on December’s 1.6% – inflation is still on the up (if we ignore the slight month-on-month decline, which in my view we should because it’s short-term noise).
However, the lower-than-expected number saw the pound sell off just after the figures came out.
This prompted one analyst I saw to note that the market sees less inflation as bad for the pound even though the threat to the UK economy is wages failing to keep up with rising prices.
And it got me thinking…
How big a threat is this?
Hold that thought. First, let’s quickly recap why a lower-than-expected inflation print should push the currency down.
Unless you’ve been in a cave the last ten years, you may have noticed that official inflation rates have has been rather subdued by historical standards.
This, of course, has led to central banks pursuing ultra-low interest rate policies (among other wheezes).
As inflation in advanced economies finally ticks higher, it signals that a) underlying economic activity is getting more vibrant and b) the relevant central bank may be more likely than otherwise to raise interest rates.
Now, I don’t actually believe the Bank of England is anywhere close to raising rates in any meaningful way.
Yes, the Federal Reserve has started doing so in the US – and may go for another one next month (for the record I’m writing this ahead of fed Chair Janet Yellen’s testimony before Congress this afternoon).
But here in the UK there’s a much bigger proportion of people exposed to a rate hike via their mortgages. The Bank of England will tread very lightly indeed.
Still, the currency traders’ logic is there. The higher inflation goes, the more attractive the currency.
Note that it’s not just policy rates that matter – higher inflation makes bonds less attractive, which (other things equal) pushes up their yields, attracting capital from abroad.
So what are we to make of this idea that, actually, higher inflation would be bad for Britain’s economy because it means real wages (i.e. what they’re worth after inflation) could fall.
Again there’s a logic here. But I’m not sure I totally buy it.
The logic is that wage growth has been sluggish and will continue to be sluggish.
Why? Well one answer is what’s come to be dubbed the productivity puzzle – the phenomenon of declining productivity (as measured by statisticians).
Productivity growth, so the theory goes, is the driver of real wage growth. If “stuff” can be made more efficiently, everyone can be better off.
Labour (the factor of production, not the political party) takes its share of this bounty in the form of higher real wages.
So if productivity growth is weak – as the data suggest it has been – then real wage growth will also be weak. That’s the idea.
Q: Will real wage growth remain weak?
A: Who knows?
Seriously, this one of those economics questions that no one really knows the answer to until it’s in the rear view mirror.
I can find you economists saying the real wage growth outlook is dreadful (here’s the IFS last autumn, as reported by Reuters) and others who say it’ll pick up starting this year (e.g. this Telegraph story about an Oxford Economics report).
But whatever happens to real wages, I suspect nominal wages should be in a decent position to keep pace with rising prices.
Well, for one thing, rising prices make it easier for many employers to pass on the cost of higher wages.
And for another, they create a bigger incentive for employees to demand pay increases or else they’ll look for work elsewhere.
Of course, given all the political talk in recent years about “squeezed middles” and the “just-about-managing”, you’ve a right to be sceptical on this point.
If it were a simple case of people demanding a pay rise, you may be thinking, then why have they waited so long?
Well, to repeat a point from above, I suspect sluggish price growth may have made it harder for employers to agree to higher wages that they can’t pass on.
And so higher inflation may find employers growing a little less stingy.
There’s also evidence that employees may be in a better bargaining position.
The Office for National Statistics actually publishes its next labour market bulletin tomorrow, but going from last month’s (which covers September to November last year), there are signs the labour market is tightening:
- Average weekly earnings growth rose in 2016. Using the figure that excludes bonuses, earnings growth went from 2.0% for the three months to December 2015 to 2.7% for the three months to end-November;
- The unemployment rate reached an eleven-year low;
- In early 2016, the number of vacancies topped 760,000 for the first time since at least 2001 (that’s as far back as the data series I’m looking at goes);
- Giving than bald number some context, the number of unemployed people per vacancy fell to its lowest level since January 2005, at 2.1 (it’s never been lower in the entire data series).
Some caveats. Average weekly earnings isn’t a brilliant measure; for example it doesn’t include earnings of self-employed people.
More to the point, it showed slightly stronger earnings growth than we’ve seen since for several months in 2015 – and that proved to be something of a false dawn.
Still, though. If this isn’t what a tight labour market looks like – at least from an official statistical point of view – then I’m not sure what is.
My point is that we can’t automatically assume that inflation won’t be met by higher wages, and that these won’t at least keep pace with the cost of living.
It could well be that wage growth has been waiting for inflation all this time rather than the other way round.
I got curious and started wondering if it’s actually inflation that leads wage growth, and the wage-push inflation story of economics textbooks is misleading.
So I started to look at the literature – and immediately regretted it.
This is one of those economics rabbit holes where you end up following a never-ending trail of on-the-one-hand-on-the-other-hand breadcrumbs (to wantonly mix up my children’s stories).
That said, I did manage to find some suggestion that prices may lead wages and not the other way round.
For example, this paper from the Cleveland Fed states that “the results in this literature are quite mixed but lean slightly toward suggesting that price inflation Granger causes wage inflation”.
If you’re wondering what the hell “Granger causes” is supposed to mean, then let me make your day.
This is one of those fun economists’ terms that makes non-economists shun us.
Basically, it if one variable, x, Granger causes another, y, it means that x contains useful information for predicting y.
I’m duty-bound by my Hypocritic Oath (if economists had an oath, that’s what I’d call it) to point out this categorically isn’t the same as saying “x causes y”.
It just means you can use x to get an idea of what y is going to be in future.
Mealy-mouthed? Sure. But it does speak to a desirable cautiousness when it comes to interpreting the data.
The example I was always given is that the weather forecast Granger causes the weather.
Now, obviously the heavens don’t open because the weatherman said yesterday it would rain.
But you can use the information in the forecast to improve your assessment of whether it will rain or not.
I hope you enjoyed that technical interlude.
Back to wages and inflation, the (marginal) finding from across the literature that “price inflation Granger causes wage inflation” implies – albeit tentatively – that, yes, inflation moves first and wages move afterwards.
But it doesn’t say this is definitely always the case, and certainly not that one causes the other.
Economists never categorically say anything if they can help it (that sounds like a barb, but I actually think thoughtfulness is an underrated quality. Sue me!)
Let’s wrap this up.
We started with the worry that inflation will be terrible because wages won’t be able to keep up.
And that may turn out to be the case. But I’d argue there’s a very good chance it won’t – and that wages should at least keep rising in nominal terms, and keep pace with higher prices.
Let’s see. Tomorrow’s ONS labour market bulletin may make an instant fool of me!
Oh, and I’ve managed to get this far without mentioning the elephant in the room: Brexit.
If Brexit does turn out to be as hard and ugly as some fear, then I reserve the right to throw all of the above in the bin and start gibbering “Stagflation!” at anyone within earshot.
In the meantime, though, I’m going to wait for the evidence before getting too worked up.