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The pressure on UK living standards Samuel Brittan Financial Times 29/02/08 While the army of investment analysts has been trying to guess whether the Bank rate will be cut by a quarter per cent, a half per cent or not at all - it could even rise - the governor of the Bank of England said something much more important and interesting in his press conference on the Bank's February inflation report. It was that the UK faced "a genuine reduction in our standard of living compared to where it would otherwise have been". Despite the usual get-out qualifying clause, it made me sit up. One can argue indefinitely about how to measure the standard of living. The Bank apparently measures it by real take-home pay, defined as "households' post-tax wages and salaries per employee divided by the consumption deflator". The latter is an inflation index derived from the national income data, which in principle is far superior to the three inflation indices that the government publishes every month. Unfortunately, it appears only every quarter after a considerable lag and is subject to revision; so it would be difficult (but not impossible) to use it as a target. In any case, the Bank's take-home pay index has already been squeezed from an average rise of 3 per cent in 1997-2002 to 1 per cent in the succeeding five years even before the further squeeze now envisaged. The main reason given by Mervyn King for the squeeze on living standards was higher food and energy prices. But this is not all. The governor was hoping for a rebalancing of the economy with a diversion of economic growth, at the margin, from the home market to exports. He pretty obviously welcomed the recent fall in sterling - 9 per cent since last August - as an aid, although no one in his position is going to call for a further depreciation before the event. A third element is that the Bank expects more slack to develop in the economy with growth below trend for about two years and a "modest increase in unemployment". The Bank also expects some increase in the savings ratio and therefore a slower growth in consumption. My concern is not with the accuracy of these expectations, but with their implications. The governor is, in effect, saying that a squeeze on living standards is warranted; and so long as it does not get out of hand he does not think the monetary policy committee could or should prevent it. What will the Bank do if the squeeze does not happen? For, as Mr King rightly said, he "cannot forecast the future". Should the Bank tighten policy to make it happen? I can imagine him saying it all depends on the reasons why not. If it is because commodity and energy prices unexpectedly drop he would breathe a sigh of relief. But what he, like most other western central bank governors, fears is that organised labour would try to engineer a temporary escape from the squeeze by embarking on a wage-push spiral. Indeed, central bankers go on so much about this possibility that they risk goading unions into just the course they dread. How much of this strategy should one buy? If it concerned the UK alone, I would say most of it, with one exception about the explanation. The governor explains that if the MPC raised interest rates sharply to try to eliminate in short order the near-term inflationary bulge it would run the risk of the consumer price index in two years' time falling below the 2 per cent target. This has become a ritualistic incantation. The trouble with this in technical terms is that it assumes knowledge of the shape and position of the future short-term Phillips curve (which is supposed to connect unemployment and inflation) that we simply do not have. In commonsense terms, very low inflation is not in itself an evil. It is only bad when it is associated with a depression, which it sometimes is but not always. I can understand the Bank's determination to show that amid all the hysteria about the credit crunch it is sticking to the inflation target given by the chancellor of the exchequer; but central banks are also expected to support wider government objectives so long as this can be done without generating inflation; and these always include growth and employment. There is no reason why the governor should refrain from mentioning the threat to these as his reason for not taking draconian action against commodity-generated price increases. My worry of substance relates to the international context. Despite the rise in commodity prices, there are recessionary pressures throughout the western world. Should the UK risk adding to them? The orthodox answer is that any expansionary policies should come from Asia. But how realistic is this? China already has a 7.2 per cent inflation rate; and how many of the oil producers could sensibly absorb much more domestic spending? A convincing justification for the UK not following the US and pulling out all stops to offset the credit crunch would have to depend on some combination of the following considerations. The US faces greater recessionary dangers than the UK, which is now too small a part of the world economy (just 5 per cent) to set an example; and the US still has the broadest shoulders to bear the expansionary burden. We can all moralise about the risks that Ben Bernanke, Federal Reserve chairman, is taking to keep the US afloat; but many of us must feel a sneaking relief that he is taking them.
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