Despite the Monetary Policy Committee (MPC) voting to hold interest rates at their historic lows of 0.1% last month, Bank of England governor Andrew Bailey has indicated his finger is still on the trigger for a rate hike in the near future—citing tighter labour markets as ‘the biggest issue’ now. Contrary to the bank’s own forecasts, the end of the furlough scheme hasn’t led to a significant increase in unemployment, with BoE chief economist Huw Pill claiming the vast majority of people on furlough have now returned to work.
Another member of the MPC, Michael Saunders, stated that evidence of rising wage growth has persuaded him that stimulus should start being withdrawn. The problem with this thinking is that while wages have risen, inflation has risen more (see Figure 1), cancelling out any wage gains made by workers.
It isn’t clear that increasing interest rates will have any impact on lowering prices. The nascent resurgence in inflation being experienced across the world is primarily still due to supply chain disruptions. The mechanism by which rising interest rates are supposed to impact inflation is essentially by increasing unemployment, which weakens workers’ bargaining power and thus slows wage growth. But lowering wage growth won’t do anything to address supply side constraints or energy shortages, which are a driver of ‘cost-push’ rather than ‘demand-pull’ inflation.
The trade-off for policy makers between creating jobs and wage growth, while simultaneously controlling inflation, goes back to a 1958 paper by economist William Phillips on the relationship between ‘Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957’, which became a cornerstone of macroeconomics. The paper identified the correlation between lower unemployment with higher inflation and vice-versa (see Figure 2).
The explanation for this relationship was that as unemployment decreased the ability of workers to bid for higher wages increased due to less competition in the labour market. Higher wages mean more income to spend on goods and services, which leads to prices going up. This is bad for net creditors and net savers, because the inflation cancels out the interest on savings. By contrast, workers and net borrowers benefit from rising wages and prices, as it allows them to pay off their debt more quickly, which is depreciating in real terms relative to their income.
As such, policy makers try to balance the conflicting interests of creditors (such as banks) who want low inflation in order to protect returns on their savings and investments and the workers who want less unemployment in order to get higher wages. The target policy makers strive for is called the ‘NAIRU’, which stands for ‘Non-Accelerating Inflation Rate of Unemployment’.
However, after the 1970s, the Phillips Curve paradigm broke down following the collapse of the Bretton Woods system of fixed foreign exchange rates against the US dollar, combined with the rising oil prices brought on by the OPEC embargo. These events created an inflationary spiral in the US and UK due to currency depreciation and rising energy prices. Business input costs were increasing alongside worker demands for higher wages. As such, corporate profit margins fell, and with them, the incentive for investors to lend; with revenues falling and restricted access to credit, businesses began to fail. Unemployment reached 6%, while persistently rising import and energy costs drove inflation to 25%.
Thatcher’s solution, following the example of President Reagan and Federal Reserve Chair Paul Volcker in the US, was to launch an offence on labour by breaking the unions, weakening collective bargaining rights, and increasing interest rates, which ensured that workers couldn’t bid up wages. They succeeded in bringing down inflation, but at the cost of unemployment reaching 12% by the mid-80s. Due to the weakening of labour rights by Thatcher and Reagan, lower unemployment no longer corresponds as strongly with higher wages or inflation (see Figure 3).
By raising rates now, the BoE hopes to slow the rate of credit growth and therefore cause a contraction in the broad money supply, thus lowering businesses’ ability to roll over debt or expand. This would mean less demand for new jobs or at worst defaults for some businesses, leading to job losses. Small and Medium enterprises (SMEs), which account for around two thirds of UK employment, would be particularly hard hit by a rates rise due to their taking on record levels of debt during the pandemic.
This highlights a further contradiction in the BoE’s logic for raising rates. Even with rates so low at present, there is no appetite for borrowing among households when conditions are so uncertain. While mortgage lending reached its highest levels in over a decade in recent months, due in part to stamp duty holidays and the introduction of help-to-buy government equity loans, consumer credit is still well below pre-pandemic levels according to the BoE’s own data.
Likewise, total lending growth to SMEs and large businesses is currently negative, with SMEs having already reached maximum borrowing capacity during the lockdowns. Despite rampant price rises in the housing market since the beginning of the lockdown, which increased as much as 30% in some places, the BoE actually plans to relax mortgage lending standards to protect house prices from a future interest rate hike. It’s a stark indication of the BoE’s preference for protecting asset owners over wage earners.
A look at the BoE’s mandate puts its institutional bias in clear view:
‘We set monetary policy to achieve the Government’s target of keeping inflation at 2%.
Low and stable inflation is good for the UK’s economy and it is our main monetary policy aim.
We also support the Government’s other economic aims for growth and employment. Sometimes, in the short term, we need to balance our target of low inflation with supporting economic growth and jobs.’
After the MPC decision to hold rates low, Andrew Bailey emphasised that he wanted to counter the impression that the central bank would always choose to support economic activity over controlling inflation, saying: ‘We are in the price stability business.’ Price stability in this instance is a euphemism for putting downward pressure on wages, while continuing to allow asset prices to soar, fuelling the UK’s growing wealth inequality.
So if the solution to the UK’s ‘transitory’ economic problems isn’t an increase in interest rates, what is? The continued presence of coronavirus, with the recent emergence of the Omicron variant causing renewed consternation, is likely to continue disrupting the global economy and causing continued cost-push inflation. It is important then to ensure that wages rise in line with inflation, while at the same time mitigating the asset price inflation facilitated by low rates. Such a strategy would transfer wealth from creditors and asset owners to debtors and wage earners.
Strikes are regaining traction across the world in response to rising living costs and unsafe or insecure working conditions. In the UK, Unite boss Sharon Graham is taking a stand against fire and rehire. With corporate profits in the UK having recovered from their drop-off in early 2020 and now soaring above the pre-Covid trend, there is plenty of capacity for large businesses in particular to absorb demands for higher wages onto their balance sheets.
If wages can keep up with inflation in aggregate then businesses can pass costs onto consumers—and yes, that means inflation, but inflation is not necessarily a bad thing. If wages are going up in line with the cost of goods and services, but asset values are increasing at a lower rate or remaining constant, this effectively redistributes wealth from creditors and asset holders to wage earners and debtors.
In contrast, the government and BoE are taking the opposite approach. Banks have made record profits off the back of the pandemic but are now receiving cut in their tax surcharge from 8% to 3% (a 60% decrease), with asset prices soaring and mortgage lending standards being relaxed. Meanwhile, workers are being stiffed with an increase in the basic rate of national insurance contributions of 1.25%, which means around £240 extra NIC paid a year for most people. The introduction of a wealth tax—i.e. a tax on ‘unrealised capital gains’ above a certain threshold—an increase in dividends tax, an equalisation of capital gains tax with income tax, or even a financial transactions tax are all alternative, more progressive sources of revenue for the Treasury budget, which has the added benefit of specifically curbing inflation in asset markets.
The moderate inflation currently experienced in the UK has nothing to do with excess demand or an excess of credit supply. Rather, it is the result of persistent supply chain disruptions and shocks to the international energy market, exacerbated to an extent by tighter domestic labour markets. As such, the decision to raise rates only serves weaken the bargaining power of labour.
Instead of leaving the BoE to resolve all of the UK’s economic issues through monetary policy, which has proven impotent at best, the government should be using a holistic approach to the Covid-economic crisis by implementing policies that curb asset inflation, while supporting wage increases in line with inflation. This would address the country’s growing wealth disparities. Likewise, maintaining low interest rates and borrowing for the purposes of alleviating the costs of energy shortages would help households deal with the difficult winter ahead.
Running the UK economy hot and targeting moderate inflation wouldn’t be an ‘anti-business’ policy, either—at least from the perspective of the heavily indebted SME sector. Typically, inflation is seen as bad for businesses because capital markets are unwilling to lend to them if they fear the interest they receive on loans will be eroded by inflation. But if demand is weak and businesses have high liabilities to asset ratios, they are already an unattractive prospect for potential lenders. Inflation could help to ‘cancel out’ the mountain of the debt built up by SMEs during the pandemic.
Instead, the BoE is holding labour and SMEs at gunpoint with the prospect of raising rates. Meanwhile, Sunak is imposing regressive tax hikes that are likely to increase in-work poverty, while making no attempt to increase taxes on the wealthy, who receive upwards of 13% of their income from capital gains. This approach amounts to a concerted strategy by the BoE and Chancellor to protect the assets and investments of the wealthy—at the expense of the heavily indebted, and of workers.