130 NEW ECONOMY

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hroughout 1993, headline inflation was less than 2 per cent. Does this mean the T inflationary psychology of recent

decades has at last changed? Is inflation really dead?

The rate of &tion is determined by people maiung many and varied decisions about pnce- setting, the quantities of goods and services to buy at prices set by others, and by the rate of pay at which people are prepared to work. These decisions are based on their perception of what has been happening to prices, wages, employ- ment and so on, and of their future prospects.

Is the recent record of low inflation explained by a change in the relationships between prices and wages? Or is it merely that the factors that usually drive the mfla- tion spiral have been sluggish recently, while the funda- mental relationships have re-

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In the simplest sense, price rises are deter- mined by producers when they market their output. From time to time, they reset their prices, aiming to reflect any rise in their costs and to charge the highest rate the market can reasonably stand. This means high wage set- tlements will generally imply large price rises. However, if labour productivity is increasing rapidly, a rise in wage costs will be offset by the greater output of each employee, and there will be less need for large price rises.

Wages rises are generally thought to be ~

''When activity expands again, the

upturn in demand for primary commodities

will have the same effect on prices as

i t has had in previous cycles"

influenced by a desire to maintain purchasing power. So the main determinant of a wage increase is the rate at which prices have been rising. Hence the spiral - wage rises cause price rises and the price rises lead to further wage rises.

Prices also respond to in- creases in the cost of material

mained the same? If the relationships have not changed, then inflation can be expected to rise as soon as other factors return to normal.

The inflation spiral The key elements in determining inflation are output prices, wages, productivity, com- modity prices and the exchange rate.

and fuel inputs. If primary commodity prices are f a h g , the pressure for high price rises will generally be weaker. However if the country's exchange rate is falling against that of other countries, imports become relatively more expensive. This can moderate and even eliminate the deflationary effect of falling world commodity prices.

lQ7Q-3535/94/03Q13Q + 05 SQ8.QQIQ C THE DRYDEN PRESS

INFLATION DOWN - BUT WILL IT LAST? 131

There is a secondary spiral. If domestic in- flation is higher than inflation in other coun- tries, there is downward pressure on the ex- change rate. And a falling exchange rate re- sults in larger rises in material and fuel costs than would otherwise have been the case.

What drives the inflation spiral? The most important influences on inflation are world commodity prices and domestic economic activity. In recent decades, the ef- fect on domestic price inflation of booms and slumps in world commodity prices has been clear. The peaks of UK domestic inflation in the 1970s and 1980s were associated with massive increases in the prices of oil and other primary commodities. By the same token, a significant trough in price in- flation in the UK and elsewhere has been the collapse of primary commod- ity prices in world markets.

Domestic output affects UK inflation rates through a number of chan- nels. In each case, however, strong economic activity implies a higher level of inflation.

First, price setters respond to any expansion in demand partly by

feature of the current

ward pressure on the exchange rate and so tends to lead to a greater increase in domestic input prices for a given increase in world com- modity prices.

Fourth, labour productivity tends to vary over the economic cycle, driving up inflation at times, pulling it down at others. But labour productivity probably has little long-lasting effect on inflation. This is because the effect on price-setting of a change in the trend increase in labour productivity is likely to lead, in the longer term, to an off-setting shift in the wage- price differential.

Has wage bargaining changed? The Chart shows that, as we might expect, the growth of average earnings in UK manu- facturing is closely linked to the sum of in-

80 81 82 03 84 85 86 87 88 89 90 91 92 93

Note: The trend increase is the mean of the eight quarter moving averaga of the annual change and the average change over the twenty years to 1992

producing more, but partly by raising prices. Second, higher levels of activity mean in-

creasing employment and lower unemploy- ment. Both of these usually imply higher wage settlements for the same level of price inflation.

Third, higher activity in the UK means more imports, and therefore a greater de- mand for foreign currency. This puts down-

flation and the trend of productiv- ity growth in manufacturing.

The Chart seems to suggest that there was a tempo- rary shift in the re- lationship between these factors (eam- ings and inflation + p r o d u c t i v i t y ) around the end of the 1980s. For about two wage rounds, average earnings seemed to grow at roughly the same rate as in the previous year,

instead of reflecting the increase in price inflation. During this period, price inflation topped 10 per cent at one point, while the rise in manufacturing earnings - usually 2-4 per cent higher than inflation -barely rose above 8 per cent.

A wage equation But this apparent change in the underlying

132 NEW ECONOMY

relationship between wages and the factors that drive them turns out to be illusory, a temporary aberration. We can illustrate this with a ‘wage equation‘ estimated over sev- eral periods from 1966 to the present, which suggests there may have been little change in the structure of wage setting in the UK since the early 1980s.

Our ’wage equation’ tries to explain the behaviour of wages over the period as being due to the change in unemployment and its deviation from the non-accelerating infla- tion rate of unemployment (NAIRU - see Driver and Wren-Lewis, New Economy, Spring 1994), RPI inflation and trend pro- ductivity growth. The impact of these fac- tors when looking at the period 1966-84 have been compared with the impacts obtained for 1979-93.

RPI inflation has a similar effect in both periods: a 1 per cent rise in inflation leads to a 1 per cent rise in wages.

The estimated effect of a change in unem- ployment is smaller over the later period than over the earlier period, but not sig- nificantly so. (For every 1 per cent rise in unemployment, wage increases are likely to be lower than they would otherwise have been, by about 0.3-0.5 per cent.) The level of unemployment appears to have rather more effect in the later period. But again, the difference is not sigruficant. (in a quarter in which the rate of un- employment is 5 percentage points higher than the NAIRU, wage settlements are es- timated to be, on average, about 0.2-0.5 per cent lower than if unemployment had been at the NAIRU.)

According to this equation, the fall in wage settlements since 1992 is explained not by a change in the process of wage bargaining but by falling price inflation and high and increasing levels of unemployment caused by the recession. Of these, the most impor- tant factor behind low increases in average earnings in 1993 is the low level of price increases.

Has price setting changed? A price equation

As with wage setting, there may have been a change in the way firms set prices. However, a ’price equation’ estimated over the period since the late 1960s reveals no evidence of structural change in recent years. This price equation explains the path of producer out- put prices (often called ‘factory gate’ prices) mainly in terms of the change in unit labour costs (the cost of the labour needed to produce a unit of output), the cost of material inputs and the change in manufacturing output.

So what, according to the price equation, has been creating the unusually low price in- flation in recent months? The answer is that there was a concurrence of three downward influences, not unrelated.

First, there were quite substantial falls in world prices of primary commodities - par- ticularly oil - imported into the UK. So even the fall in sterling, following the UK’s 1992 exit from the E M , did not lead to commodity import prices putting much upward pressure on UK price setting.

Second there was an increase in labour pro- ductivity. This was so great that at some points it was higher than the (unusually low) wage increases of the time. Indeed, at times unit labour costs actually fell.

Third, there was a fall in UK manufactur-

it is not surprising that with all these things occurring together price inflation has been very low.

ing output.

But will inflation stay low? Primary commodity prices

The recent behaviour of primary commodity prices means that overall input prices for manufacturing were no higher, in sterling, at the start of 1994 than in late 1990. If there had been no domestic inflationary pressures (and ignoring time lags), inflation in the UK would have averaged zero over the past three

INFLATION DOWN - BUT WILL IT LAST? 133

years. Given this international background, it seems less surprising that inflation in the UK has been so low in recent years.

There is no reason to suppose that primary commodity prices are less responsive to the pressures of world demand and supply now than in the past. Indeed, there have been some sharp rises in commodity prices re- cently - sugar, cotton and coffee, for example - caused by temporary shortages of supply following crop failures. Oil prices have also fluctuated, from $16 a barrel to $13 and then up to $16 again during the course of a few months. Such fluctuations reflect variations in supply, upward revisions to expected de- mand, and speculation about future orches- trated cuts in output. Metals prices, which fell sharply in 1993, have been rising since the start of 1994.

This is puzzling some analysts who believe the rises are caused largely by speculation follow- ing uncertainty about the true level of stocks. If this is correct it reflects the likelihood of short- ages of supply in the future.

So the evidence suggests that pri- mary commodity prices are as sensitive as ever to a de-

recession, with demand and output begin- ning to rise, labour productivity tends to rise apace for these reasons. 0 Expanding output will, to begin with, be

met without a commensurate expansion in employment. The least efficient processes are the ones that will have ‘died’ during the course of the recession.

0 New processes coming on stream will use the latest technology and so will be more efficient than earlier processes.

Wage increases will be discounted by these large rises in labour productivity before af- fecting price increases. And at this point in the economic cycle, increases in wages will still be low, reflecting the low price rises of the recession and employees’ fear of unem-

5 6 7 8 9 1 0 1 1 1 2

percentage of workforce unemployed

ployment. For these rea-

sons, output per person in UK manufac tu r ing grew more than 6 per cent in the year to June 1993. This meant that annual wage increases of 6 per cent could have been accommo- dated in manufac- turing with no in- crease at all in prices. The actual increase in earn- ings has been less

mand/supply imbalance. When activity ex- thanthis. pands again in the developed world, the up- turn in demand for primary commodities will therefore have the same effect on prices as it has in previous cycles. And a rapid rise in the prices of primary commodities can have a powerful effect on the rate of inflation in de- veloped countries.

Labour productivity When the economy begins to pull out of a

Although there has sometimes been high productivity growth during the past 20 years or so, at no other time during the period did earnings growth in manufacturing actually fall below the rate of increase of labour pro- ductivity, leading to downward pressure on price levels. But productivity gains of this or- der cannot be expected to continue for long. Indeed, figures for early 1994 show produc- tivity rising at just 2-3 per cent on a year earlier

134 NEW ECONOMY

for both manufacturing and the whole economy.

Domestic activity and unemployment The Chart shows the trade-off between the growth in average earnings and the rate of unemployment in the UK in recent years. This well-established short-term relation- ship, the Phillips Curve, shows that falling unemployment is associated with higher wage increases in the short term, and rising unemployment with lower wage rises.

As the Chart illustrates, for quite substan- tial periods - 1980-85, for example - this rela- tionship remains broadly stable. From time to time, however, it will shift inwards or out- wards, improving or worsening the short- term trade-off between unemployment and inflation. It is the variables we have discussed - world commodity price inflation and labour productivity -that most often cause a shift in this domestic inflation/unemployrnent rela- tionship.

Between 1990 and 1992 the UK economy moved downwards and outwards along a Phillips trade-off that had been shifting in- wards since 1987. During 1993 the curve moved inwards again, improving the infla- tion/unemployment trade-off. By mid-1994, the curve appeared to be remaining stable at its new, more beneficial position. The UK economy has moved along it, inwards (reduc- ing unemployment) and upwards (increasing wage inflation slightly).

These beneficial shifts have been caused mainly by falling primary commodity prices in world markets since 1987, by the temporary change in the behaviour of wages relative to the state of the economy in 1989 and 1990, and by the recent rapid increase in UK labour pro- ductivity.

UK wage-setting process, the present situ- ation has arisen mainly as a result of falls in world prices of primary commodities, com- bined with the recent recession in the UK and the unusually high labour productivity growth as the recession ended.

When world economic activity revives and UK domestic output begins to grow again, the survival of the same old relationships - which have been instrumental in determining a low inflation rate when activity was low - sug- gests that prices will be set so as to rebuild profit margins and that wage settlements will be consistent with rising real incomes. If this takes place, the rate of UK price inflation will climb once again.

The future - more of the same? The current low level of price d a t i o n does not herald a new era in which the UK has no inflation. Although there is evidence of a re- cent temporary change in the operation of the