Sticky wicket

The UK has had the highest passthrough of price shocks into wages, making it most likely to endure sticky services inflation, in our view. This likely reflects less well-anchored inflation expectations and could put the Bank of England in a dilemma as the labour market begins to crack. Core inflation has fallen from 7.1% in May to 6.2% in August, and we believe it should continue to improve. But stubborn survey data suggests it might remain above target.

In my recent blog post Price-wage echo, I argued that the tug-of-war between firms and workers to maintain their real incomes after the pandemic and energy price shocks would lead to sticky underlying inflation. I have long thought that the UK could be most vulnerable, given that it likely has the least well-anchored inflation expectations among its global peers. This is because it has had the highest ‘inflation memory’ of recent decades, which I use as a proxy for inflation expectations.

After the 1970s oil price shocks, younger households had higher inflation expectations than older ones. Young people were scarred by successive oil shocks, but older ones could still remember the good times.

I argued high inflation memory likely explained the loss of competitiveness of Southern Europe in the 2000s after the euro launched. They still remembered the peseta, lira and drachma and periodic currency devaluations to bail them out. Similarly, I argued the sharp fall in oil prices in 2014 explained subdued US nominal wage inflation despite a tight labour market. The wage-Phillips curve wasn’t REALly broken.

So why am I pessimistic about the UK? Successive depreciations of the pound after the global financial crisis and EU referendum have kept UK inflation higher than its peers, meaning the ‘deflation fears’ were never as intense in the UK as elsewhere. So a sharp rise in prices is more likely to be treated as ‘normal’ than ‘exceptional’. In other words, price rises are less likely to be forgiven and forgotten by price and wage setters.

In a recent paper often cited by central bankers: What caused the US Pandemic-Era Inflation?, former US Federal Reserve chair Ben Bernanke and Olivier Blanchard estimated that price shocks should have a 20% passthrough to wages, inflation expectations and medium-term inflation. The UK has experienced a 65% passthrough of peak inflation shock into wages versus 44% in the US and 39% in the euro area.

It's uncertain what happens next. Higher wages don’t necessarily mean higher prices. They could mean lower profit margins. But surveys of firms’ price expectations have stopped improving (falling) in both the UK and the euro area, with higher wages cited. So we think the high passthrough of previous price shocks into wages is likely to keep services inflation sticky.

This poses a dilemma for the Bank of England. The labour market is starting to crack. Unemployment has risen by ¾% from its lows as surveys of recruitment consultants point to falling job placements. Yet wage data points have been persistently strong. Consensus expects modest GDP growth will return inflation to target across the advanced world. By contrast, we believe a global recession will unfortunately be required to ultimately tame inflation.