Do we have inflation? Sure, some prices have been rising sharply recently, but then again the prices of some things are always rising faster than others – be it dotcom stocks rising faster than bonds, or house prices faster than salaries, or more recently food prices, or oil. But relative price increases, however robust in themselves, don’t equate to self-sustaining inflation.
Inflation, at least what economists call wage-cost-push inflation, occurs when each rise in final prices triggers a chain-reaction with demands for higher wages to compensate, which forces employers – already squeezed by higher raw material costs – to raise prices. In an ultimately self-defeating vicious circle, rigidly unionised labour forces can demand wages often in excess of historic price rises, in anticipation of further real wage erosion ahead of the next round of bargaining. Desperate employers hold out, triggering strike action and shortfalls in output, while sometimes generous wage offers are refused while holding out over other issues.
Is that what we are about to see? I don’t think so. Let’s look first at the effect of the high oil price. Oil is included in consumer price inflation (CPI), so a higher oil price (relative to other goods) pushes up the measure of inflation. But what does this do to demand for other goods? Oil is an essential. At least short-term we can’t cut our use of it, so we’re forced to make savings elsewhere. I might use fewer taxis, cancel the gym membership and cycle to work. I might even save more just in case. This all has the effect of cutting expenditure on non-fuel items, especially luxuries. “Inflation”, if caused by higher oil prices, thus actually has a deflationary impact on consumers’ behaviour.
So it makes sense that when economists and central bankers look at inflation, they strip out the impact of oil and, in the same vein, that they exclude mortgage payments and food to create a measure of “core inflation”. Mortgage payments are out because at the very time inflation is a concern, the policy response is to raise rates, and that would make mortgage costs go up and inflation immediately look worse the more that was done to tackle the problem. Food costs are also excluded from headline inflation because they can be affected by non-economic factors such as the weather, transport costs (oil), and because the food replacement cycle is very short, so prices tend to be volatile.
Core CPI tells central bankers what the underlying inflationary pressure is like for everything that isn’t essential to life – ie, that we can’t easily change our demand for. British core CPI is just 1.4% and, what’s more, has been falling for the last year. But people buy food and fuel every day, so their perception is that prices are rising more strongly than they are. This, therefore, is the issue. Even if prices aren’t rising that fast in reality, will people’s perceptions of inflation rise and, if so, will they ask for higher wages to compensate? And will they get them? The first point to make here is that oil prices – the thing leading their expectations of inflation – are on the turn.
Global oil consumption growth peaked in 2004 at 2.75%, before falling to just 0.75% last year, while American vehicle miles had fallen 4.3% by March, the sharpest slowdown for at least sixty-six years. Demand growth should slow even more this year as emerging markets’ governments, unable to keep paying out to subsidise domestic fuel prices, stop doing so – just as years of higher prices bring on increased supply. Given all this, I think we can expect prices to keep falling. So maybe workers won’t ask for more money. But what if they do?
Only one thing stops people asking for higher wages: the fear of unemployment. In the 1970s, a rigid, highly unionised workforce felt confident enough about job security to demand higher wages or strike. Today’s more flexible workforce may well not. Note that American productivity growth on a rolling four-quarter basis is up from 0.1% growth to 3.2% in under two years, even as unemployment has risen from 4.4% to over 5%. If you’re lucky enough to have a job, who isn’t going to work that little bit harder to keep it?
Unit labour costs on that same four-quarter basis have fallen from 4.4% growth to just 0.3%. Throw in house prices more than 16% off the top, mostly in the first quarter, and it’s no surprise that a disenfranchised workforce is feeling pretty low. The ABC News weekly consumer confidence survey scored its lowest rating since its inception in 1985. This does not look like a workforce that will strike for higher pay.
However, the once all-powerful American consumer also doesn’t look like he can take any non-essential item price hikes either. That means firms won’t be able to pass on higher raw material costs. On the plus side, if they can control the wage bill, they may not need to. In developed countries, about 80% of input costs are labour.
This is why rampant energy and food prices have so far had so little impact on even our headline inflation. While raw materials prices, as measured by the PPI, may well be rising at 6.5% a year, they only make up a fifth of all costs. The other four fifths are labour – and labour unit costs are hardly rising at all. So input costs are actually rising at between 1.5% and 3%, well below headline CPI growth of 3.9%. Good news for corporate profit margins, assuming, of course, that recession doesn’t mean firms have to start slashing prices in order to sell anything at all.
That’s a point worth making about Britain too. We are moving into recession – no doubt about it. It doesn’t matter if the Bank of England (BoE) lowers rates or not, the availability of credit is collapsing and the cost, if you can get it, has gone up. Whereas the best available mortgage rates in Britain were perhaps 4.5% two years ago, they’re about 7.25% now.
It makes no difference that the BoE has cut rates from 5.75% last summer to 5% now; none whatsoever. The West is now experiencing rising borrowing costs, which has become the catalyst for a correction in a mightily overvalued housing market, and hence for a massive economic downturn. In all three of the major postwar house-price crashes, quarterly real house prices went deeply negative coincident with (1973), or even before (1980 and 1989) annualised real GDP did. In the last downturn, house prices fell about six months before recession hit and the transmission mechanism is crystal clear.
House-price growth is the main driver of mortgage equity withdrawal (MEW), which had already fallen from 6% of disposable income a year ago to 3.2% at the end of December. Without robust MEW, retail sales could stop growing (the green line) and slow to a virtual standstill.
Negative house prices could thus soon be joined by negative consumption. With underlying core CPI of just 1.4%, whatever people might ‘feel’ about prices, what we’re actually on the cusp of is not an inflationary cycle, but a deflationary recession.