Inflation: the warning signs are there
It is quite possible that some of these difficulties are caused by Covid. However, in many cases, these problems have been building up for a long time. We are used to challenges in staff recruitment in particular areas of the country in the public sector because national wage bargaining means that wages do not respond to supply, demand and differences in living costs. But we have not had shortages on such a widespread scale for decades.
Many economists have been arguing that all these problems are a drag on growth. However, such pervasive and widespread shortages would seem to suggest that we have an economy that is running out of capacity.
It is highly likely that the problems we face across so many sectors of the economy are indicators of nascent inflation. There are other indicators too. Commodity prices are roaring ahead. In the last 14 months, the Bloomberg index of commodity prices has increased by around one-third. Shipping costs have also been soaring.
Andrew Bailey has argued that recent increases in inflation are temporary and that “it is important not to over-react to temporarily strong growth and inflation”. And many others have cited the increase in commodity and shipping prices as being a temporary phenomenon that will pass through.
If we look at these data individually, these kinds of explanations might hold water. Shipping costs can spike. A relative shortage of particular commodities can cause their prices to rise rapidly if supply is slow to respond. And, from time to time, for all sorts of reasons, there might be a shortage of labour in particular industries – especially if training times are long. But the problems in the economy today are widespread and pervasive.
As the old saying goes, inflation arises from “too much money chasing too few goods”. Since the beginning of the Covid episode, we have had a huge increase in the money supply, with £300 billion of new money being printed. Covid caused a supply problem, since the Government effectively banned economic activity of certain types, and we all changed our working habits. We saw in the 1970s what happened when supply-side problems were addressed by the printing of money. Perhaps the same is going to happen again.
Inflation works its way through the system in different ways, depending on the circumstances. One of the problems of the way in which we teach economics is that we tend to focus on equilibria – the theoretical end points of economic processes. However, it is the process itself that is more important. If we print money, all other things being equal, we will end up with a higher price level. But, if central bankers are to be ahead of the game, they need to focus on the processes by which the higher price level comes about.
Inflation expectations are, in the jargon, “well anchored” at the Government’s target. This means that most people expect inflation to be two per cent per annum in the long term. Wage negotiations reflect this. So, when there is an increase in demand caused by an increase in the supply of money, various things can happen, but one thing that does not happen quickly is an increase in wages.
Typically, prices in highly efficient markets with good information flows rise first – house prices, other asset prices, prices of commodities and shipping costs. However, businesses see a rise in demand for their goods and services, and they increase their demand for inputs such as labour and raw materials.
The final prices that businesses charge tend to be sticky: businesses do not like putting up prices. And the wages of the labour that businesses employ tend to be especially sticky (with so much focus on paying staff, the statutory minimum wage is not helping here). Businesses are all planning as if there has been an increase in demand for their own products, but they can’t all increase supply. The results is shortages – not just in the odd industry caused by disruption in specific sectors, but in large parts of the economy.
We all want more cappuccinos, more housing space, more goods on the supermarket shelves, more restaurant meals, more care for the elderly and so on. But there are simply not the real resources to produce all the things that we are demanding and paying for with printed money.
Eventually, this is “resolved” by a rise in prices in the wider economy and a rise in wages – in other words, by inflation. But this can take a while to happen. This will choke off the demand for goods and services and the demand for labour; and it will do so in some industries more than in others. As a result, wages in some sectors will probably rise significantly.
If the Bank of England quickly catches up with what is going on, this process might be relatively benign. But, if it does not, four per cent or five per cent inflation for a couple of years could cause real problems. Interest rates of 7-10 per cent needed to bring inflation back down again could destroy businesses and bankrupt mortgage-holders in large numbers.
All his would also create considerable discomfort for the Government. We might think we are a long way from the events of the 1970s. However, we should remember that the events of the 1970s started in the 1960s. Twenty-seven per cent inflation did not happen overnight.
This article was first published on Conservative Home.