The end of cheap European labour has let the inflation genie out of the bottle
Today's price spikes are just a taste of what is to come as Britain reverts to the economic models of the past
Remember the “Phillips curve”, the idea that the tighter the labour market becomes, the more it pushes up wages, and therefore inflation?
It used to be the lodestar of interest rate-setters everywhere; the lower the rate of unemployment, the higher the likely rate of inflation, and vice versa.
For much of the post-war period, the Phillips curve was as good a guide as any on the likely path of inflation, and was therefore at the heart of much central bank thinking on the appropriate monetary policy stance.
But then came globalisation, the mass movement of goods, and later of mass migration of labour too.
With enlargement of the European Union after 2004, a steady trickle of migrant workers fast turned into a flood, though both the politicians and the official statistics refused at first to acknowledge it. On the ground, however, it was impossible to ignore.
Migrant workers from the accession states of Eastern Europe rushed to take advantage of Britain’s relatively open and flexible labour markets.
As a result, labour supply was no longer fixed. As Lord King, former Governor of the Bank of England, put it in the Institute of International Monetary Research’s annual lecture last week, “the output gap, the difference between aggregate demand and potential supply, became less and less relevant to monetary policy because demand was generating its own supply of labour”.
By the by, the Phillips curve became flatter and flatter, eventually making itself all but irrelevant to interest rate policy.
With Brexit, however, the narrative has changed again. According to Office for National Statistics data published last week, 94,000 more EU nationals left the UK last year than arrived, the first time net migration from the EU has been negative since the turn of the century.
In all, some 147,000 Europeans are estimated to have left the UK last year.
How much of that is down to Brexit, and is therefore likely to prove permanent, and how much the pandemic, which may be more temporary as those with rights of residency return, is not yet clear. But it certainly helps explain today’s acute labour shortages across multiple different sectors as the economy recovers from its Covid shock.
Meanwhile, the pandemic appears to have persuaded many older workers to retire early, by either giving up work entirely or at least substantially reducing their working hours.
What’s been dubbed in the US “the great retirement” has also been a notable feature of the UK labour market, further eroding the pool of economically active workers.
Again using the latest ONS data, the ranks of the economically inactive were 364,000 higher in the July to September quarter than immediately before the pandemic. That’s partly down to more young people choosing full time education over work. But the other notable feature is older workers, particularly of the self employed variety, throwing in the towel early.
Juxtaposed against an apparently shrinking workforce is a growing number of job openings.
Vacancies in August to October rose to a new record of 1,172,000, an increase of 388,000 on the pre-pandemic level, with 15 of the 18 industry sectors showing record highs.
I don’t know where the Bank of England gets the idea that inflation-busting wage increases are confined to a relatively limited number of sectors. That’s certainly not what you hear anecdotally. To the consternation of employers, workers will sometimes quit mid-shift, such is the opportunity of higher pay elsewhere.
Growth in average pay was 5.8pc in the July to September quarter, and higher still at 6.6pc in the private sector. Even stripping out the base and compositional distortions inflicted by the pandemic, wages are still rising at a fair old clip. In July, the ONS estimated that the underlying rate of growth was between 3.2pc and 4.4pc.
In any case, it is becoming ever harder for the Bank of England and its counterparts in other advanced economies to sustain the argument that current inflationary pressures are “transitory” and will soon abate.
It is certainly right to argue, as Andrew Bailey, Governor of the Bank of England does, that there is not a lot monetary policy can do about higher global energy prices and other forms of imported inflation.
Yet if a tight labour market gives workers the bargaining power to bid up wages to match, imported inflation will soon turn into the domestically generated variety, and possibly lead to the sort of wage/price spiral that bedevilled policy makers in the 1970s.
Outside the public sector and some of the utilities, the union power that fed such spirals back then has gone. But who needs the power of the union when there is a shortage of labour to bid up wages instead?
Acute labour shortages after the Black Death in the 14th century caused just such a great inflation; nobody would compare today’s pandemic to that catastrophe, which wiped out a third of Europe’s population, but you get the point.
Now of course, if the “Nu” coronavirus variant turns out to be quite as gruesome as some epidemiologists fear it might be, then all bets are off.
A vaccine-resistant Covid strain is everyone’s worst nightmare; demand in the economy would plummet anew, and we’d be back to where we were last year before vaccines began to make Covid a manageable disease.
In such circumstances, renewed inflation would be the least of our worries. Already financial markets are beginning to price just such an outturn.
But let’s assume that the Nu strain is just a passing fright; as it is, the pandemic has inflicted fundamental change on economies, or rather it has greatly accelerated a number of pre-existing trends into a series of transformational ruptures.
Home working is one such shift. The “great retirement” may also have brought forward that moment of demographic change referred to by Charles Goodhart and Manoj Pradhan in their book, The Great Demographic Reversal.
This argues that as more baby boomers retire, the proportion of active workers in the economy will shrink, substantially increasing their bargaining power. Wages and inflation will rise accordingly.
Demographic forces of this type are running alongside a number of other transformational changes that will require a significant reallocation of resource within Western economies - deglobalisation and the accompanying push for greater economic self sufficiency, decoupling from China, the political pressures for much higher public spending, and the huge investment and restructuring needed to meet climate change targets. All these things are almost bound to be inflationary.
Some of today’s spike in prices may indeed by “transitory”, but they are also just a foretaste of what is to come as we transition from a disinflationary age driven by globalisation and the mass movement of labour back towards the more closed and inflationary economic models of the past. Welcome back to the Phillips curve.
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