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The signs of British repression Samuel Brittan: Financial Times 22/11/02 Britain's policy regime of inflation targets appears to have been wonderfully successful. Inflation has averaged almost exactly the target level of 2½ per cent and has rarely strayed more than half a percentage point on either side. At the same time the International Labour Organisation unemployment rate fell almost continuously from its 7.6 per cent peak in the 1993 recession to a low point of 4.2 per cent in 2001. The sharp apparent drop in the unemployment percentage, consistent with low and stable inflation, can be attributed both to the union legislation of the Thatcher government and the welfare to work programme of the present government. But unfortunately the last stages of the apparent fall in sustainable unemployment are too good to be true. Inflationary pressures are greater than suggested by the official index of retail prices excluding mortgage interest (RPIX). This assertion will seem bizarre to many in the financial or business communities where all the talk is of profit warnings, lack of confidence, redundancies and even deflation. But it is worth looking back at some of the analysis that appeared during the early postwar decades of "repressed inflation". Inflation was then repressed by a fixed exchange rate, spasmodic pay and price controls and by rigidities such as loan rationing. Some of the mechanisms of repression are different now but the symptoms are unmistakable. There is the house price bubble, which has only been slightly reflected in RPIX, although houses are a much more important asset for the vast majority of British households than equities. Second, there has been a swing to deficit in the balance of payments. As a proportion of gross domestic product, it is smaller than it was in the late 1980s - or is in the US now. But it nevertheless reflects the funneling of excess demand into imports; and the OECD expects it to double by 2004. Third has been the agitation for higher public sector wages. One element is the increase in union power resulting from there being a Labour government. But militant union leaders find their main opportunities when the demand for labour in their sector exceeds the supply. The difficulty of recruiting teachers and nurses - but not firefighters - suggests they are being offered less than their market-clearing pay. When you see a train being cancelled for "lack of staff" or ambulance services being delayed, you know there is an overheated labour market in which pay is artificially suppressed. The devices being touted by the government, such as artificially cheap housing for new recruits to nursing or teaching, or selective immigration permits, suggests that it is trying to grant disguised pay increases to some workers without generalising them to their fellows. The conventional analysis is of a divided British economy suffering from excess consumer demand but recession in manufacturing. Someone at some stage has to put it all together and ask what the predominant pressures are. In the labour market at least, they are of overheating. Even now, private sector employers report that difficulties of retaining skilled labour are the most important influences on pay increases. It is not really surprising that the symptoms of labour market overheating are erupting after profitability has already turned down. The labour market has traditionally lagged behind the product market, let alone the financial markets. Moreover labour market forces act with delay. Unions can be pushing for pay rises long after the market has turned. The unemployment rate has now crept up to 4.8 per cent; and the best course for the Bank of England monetary policy committee would be to sit tight while demand pressures abate. It goes without saying that the chancellor needs to keep to his pre-announced cash limits for public spending. But he should avoid the mistake made by so many previous governments of getting hooked on particular pay claims as a test of his counter-inflationary strategy. In the context of cash limits, public sector pay defeats will mean fewer public sector jobs, and perhaps more unemployment generally. The official nightmare would be if headline public sector pay defeats coincided with a fall in sterling. This brings me to the punchline of Mervyn King's much-quoted lecture this week. It was that the inflation target might have to be achieved over a longer period than the present two-year horizon. In practical terms it means, in my view, not panicking into interest rate increases if sterling drops. The Bank of England deputy governor's message was that forces such as asset price bubbles on the one hand, or recession on the other, could be taken into account by varying the speed with which inflation returns to target from either direction. Given the amount of bipartisan political capital tied up in consumer-based inflation targets, this language is understandable. But we have come a long way from policy driven simply by short-term movements of RPIX.
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