James Faulkner on the Inflation genie – back in the bottle, but for how long?

Low inflation (as measured by the Bank of England’s 2% target) has enabled Mark Carney and his fellow policymakers at the Old Lady of Threadneedle Street to keep interest rates at historic lows. However, judging from figures released in the second of the IMF’s twice-yearly World Economic Outlook, there is good reason to believe that such a benign inflationary environment might not continue for much longer in the UK.

According to the IMF, one of the reasons inflation has failed to take hold, despite growth coupled with expansionist monetary policies in many parts of the advanced world, is due to the existence of an ‘output gap’ in a number countries. The output gap is the difference between the potential output of an economy (i.e. if all resources including labour and capital were utilised) and its current rate of output. A negative number indicates that there is spare capacity in the economy; whereas a positive number suggests that resources are being employed at a rate that is above what is sustainable over the long term.

The IMF puts the UK’s output gap at just -1.2%, which is much smaller than the US level of -3.5%, and compares with the UK Office for Budget Responsibility’s estimate of -2% for the UK. If the IMF’s estimate is on the money, this could spell trouble ahead for Carney et al, as it suggests the economy is nearing a point at which inflationary pressures will begin to take hold. What’s more, given the current rate of GDP growth, that time could come sooner than we think.

To better understand the inflationary landscape in the UK, we need to take a look at the UK’s labour market. While the peak to trough recession post the financial crisis was particularly deep in the UK, the accompanying spike in unemployment was much smaller than in previous recessions. This has been put down to the UK’s flexible labour market, which enabled employers in many cases to reduce workers’ hours rather than make them redundant. The flipside of the UK’s ‘flexible’ labour market is that wage pressure is very weak, and there is now a growing consensus among politicians that the minimum wage needs to rise.

This may be music to voters’ ears, but the other facet to this debate is the UK’s dire productivity performance since the crisis, which has been among the worst in the advanced economies. To a certain extent, weak productivity growth can help us account for the lack of wage growth in the economy, and it certainly suggests that if any significant upward pressure on wages were to arise, then inflation would follow. The reasoning behind this is simple. If we aren’t producing things more efficiently, getting paid more for producing the same amount can only lead to a rise in the price level – inflation.

So, in order to justify payrises in the wider economy, productivity has to be growing. In order for productivity to grow, businesses need to invest. However, as you can see from the chart, business investment has been relatively subdued since the crisis, notwithstanding record low interest rates which are supposedly there to induce companies to take risks and invest. Despite a recent upwards revision to estimates of business investment, we are only just above where we were before the crisis in real terms (see chart).

The good news is that if investment continue to rise, productivity should ultimately follow suit, thereby allowing for an increase in real incomes without putting too much pressure on inflation. However, it must be stressed that this is an organic process that needs time to play out. Should, as the polls currently suggest, a Labour government get elected in 2015 on an anti-business card, this fragile recovery in business investment could be derailed at a time when Labour wishes to push through large increases to the minimum wage. A recipe for stagflation…

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