Sunday, September 23, 2012
Inflation still too high to beat the squeeze
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

Another week, another puzzle. The latest figures for retail sales, out on Thursday, showed a marginally disappointing 0.2% drop in volumes in August.

Store sales were generally fine but online spending dropped, because we watched the Olympics and Paralympics on television rather than clicked and shopped.

That may be a sad indictment of the way we live but even after the 0.2% slip, retail sales volumes were 2.7% up on a year earlier. Sales in August 2011 were a little depressed because of the riots but it was still the case that non-food sales last month were a hefty 5% up on a year earlier; more of a boom than a shoppers’ strike.

I promised a puzzle. Retail sales have grown, with volumes 1.4% up on their pre-recession peak in the first quarter of 2008.

Now let us look at consumer spending more generally, which is what matters for GDP (gross domestic product). In the latest quarter, April-June, spending in real terms fell 0.4% and was down by 0.8% on a year earlier. Not only has it failed to get back to its pre-recession levels but it is still a substantial 6.3% below it.

Retail sales, covering what people spend in stores as well as petrol and diesel purchases, are not the same as consumer spending. The latter includes gas and electricity and other household bills, bus and rail fares, and expenditure on housing, recreation, culture, hotels and restaurants.

Some of those, like nights out or tickets to sporting events, we like spending money on. Others, like household bills, insurance and train fares, we do not.

You could argue the current mix of rising retail sales and depressed consumer spending, is on balance better: people are spending less on things they would prefer not to spend on, and more on goods in the shops.

Even so, it is odd. Retail sales and overall consumer spending are usually closely correlated. It is unusual for them to be moving in opposite directions.

As far as the Bank of England is concerned, it is the wider picture for consumer spending that matters and, according to the latest minutes of its monetary policy committee (MPC), we are heading for another disappointment. Despite last week’s drop in consumer price inflation to 2.5%, the MPC fears - again - it will disappoint on the upside in the coming months.

“Any sustained recovery in output would probably need to be accompanied by a pickup in consumption...,” it said. “The prospective rises in prices for petrol, household energy and some foodstuffs would dampen real income growth in the second half of the year.”

It is not all one-way. Since the MPC met, oil prices have slipped, and this may feed through into lower petrol and diesel prices.

The read-across from above-target inflation to real income growth is not as direct as you might expect. People have other sources of income. In the 12 months to the first quarter of this year real incomes fell only 0.1%, even though inflation topped 5% during that period.

Even so, the most basic building block for a rise in spending is that earnings from employment go up more than prices. Normally it happens. In the eight years before the recession, earnings rose 39%, prices 15%. There was a real income bonanza.

But not now. The relationship has broken down. Pay, in the latest figures, is rising an annual 1.5%, well below inflation. Even adjusting for depressed bonuses, pay is rising less than 2%.

Nor is this just the result of the squeeze on public sector pay. It is rising by 1.2% but earnings in the private sector are only increasing by a slightly faster 1.8%.

There is now an official debate about how inflation is measured. Following a report from the Consumer Prices Advisory Committee, the national statsitician will consult on changing the methodology for calculating the retail prices index (RPI).

People will suspect a trick but certain aspects of the RPI, particularly clothing and footwear prices, have looked odd for a while. The so-called formula effect gap, which gives higher retail price inflation (currently 2.9%) than consumer price inflation (2.5%) may be removed.

That will not change the underlying reality, however, of prices rising more rapidly than pay. How can it be tackled? One way is for the Bank to aim, not merely for 2% inflation - its target - which it has struggled to hit, but to go for something lower. With wage growth so depressed, even 1% inflation is not too low for this economy.

The other is to look for a return to normal earnings growth. Before the crisis, allowing for what was then regarded as trend productivity growth of about 2% a year, 4% earnings growth was both consistent with the inflation target and good growth in consumer spending.

Can we return to such growth? One is tempted to say that if firms are worried about demand in the economy, as they say, part of the solution is in their own hands, in the form of more generous pay awards.

Looked at from a macro perspective, a new paper from the Resolution Foundation by Professors Paul Gregg and Stephen Machin, ‘What a drag: the chilling impact of unemployment on real wages’, does as its title suggests.

It finds that while unemployment has not risen as much as feared, at more than 8% of the workforce it has had a crushing impact on the growth in real wages.

Building on changes that were in place even before the recession - the economists think the greater sensitivity of wages to unemployment can be traced back to 2003 - Britain is a buyers’ market for employers.

The implication is that only a sharp fall in unemployment will change this. As they put it: “Real wage growth for low and middle earners will not return to significant positive territory until unemployment starts to fall significantly – probably below the levels (of between 4% and 6%) recorded in the period from 1999 to 2007.”

That is not going to happen for some time. The Bank can help by getting inflation down further. But the days when strong growth in real wages generated across-the-board rises in consumer spending are a fading memory.