Inflation will subside next year but wage growth will remain a problem

Authorities, markets and public have not grasped the scale of tightening that may soon be necessary

Pay inflation could meekly subside also. But I doubt this, without a loosening of the labour market and a rise in the numbers of unemployed

The Bank of England made a serious policy error in keeping interest rates too low for too long and carrying on with Quantitative Easing (QE) for too long. In some circles it is believed that if the Bank had not made this error we would now be spared the current inflationary upsurge. This is a gross exaggeration. The Bank is culpable, but not to that degree.

The current debate about the role of central banks in causing the current inflationary upsurge is the latest episode in a long-running controversy in economics about the cause of inflation. It centres around the relevance of the money supply versus disruptions on the supply-side to rising prices. Perhaps the most virulent outbreak – of both inflation and the debate about its causation – occurred during the early 1970s when an upsurge of monetary growth coincided with a large increase in the price of oil and other commodities.

According to the monetarist Old Believers, only money matters for inflation. Such things as Covid, interrupted supply chains and the huge increases in energy prices this year are supposedly of no relevance to inflation, other than fleetingly. To back this up, they contrast the current rapid inflation experienced by countries like the United States and the UK, which let the money supply rip, with the experience of countries such as China, Japan and Switzerland which didn’t. Allegedly, the latter group has suffered next to no inflation even though they have been subjected to the same global supply-side shocks.

In practice, this argument doesn’t quite stack up. True, China’s inflation rate is currently only 1.6pc but the economy is very weak. In Japan, headline inflation is running at almost 4pc, while core inflation is fast approaching 3pc. Japan is the land of endemic deflation, so these rates are pretty high by Japanese standards.

Switzerland is a better test, being much closer geographically and culturally. It is supposedly a country of great monetary virtue with a deeply embedded anti-inflationary culture. There, inflation peaked at 3.5pc but it is still 3pc. By Swiss standards these rates are alarming. This is a country used to inflation at zero, or at most 1pc.

Nor is it true that Switzerland has contained its inflation rate through sticking to orthodox monetary policy. The Swiss National Bank cut interest rates all the way to minus 0.75pc. Although it didn’t engage in QE of the conventional sort, that is buying bonds, it engaged massively in QE of an unconventional sort, namely through selling Swiss Francs on the exchanges and buying foreign currency in an attempt to hold down the rate of the Franc.

As a result, the annual rate of increase of its liabilities (“highpowered money”) almost reached 20pc in 2020.

Not that any of this gets the Bank of England off the hook. What would have happened if the Bank had been tougher? We would still have seen inflation close to the current level, although probably a bit lower. The economy would have been weaker, with the prospect of a softer labour market starting to be felt.

Accordingly, there might not have been the same amount of upward pressure on pay. With interest rates rising sooner, the weakness in the housing market that is now evident would also have happened sooner.

And the combination of QE being stopped and higher official short-term interest rates would have seen gilt yields much higher.

Interestingly, this holds the potential of a crisis for pension funds a good deal sooner than the one that occurred during the brief Kwarteng/ Truss episode, as a result of their investment in risky liability-driven investment schemes.

As things stand, I am pretty sure that, unless there is another surge in energy and/or food prices, inflation will subside quite markedly next year. It may already have peaked. But the ominous thing for the future is the fact that wage inflation is currently running at 6pc. (The latest figures, due out tomorrow, may show another rise.)

As price inflation subsides, pay inflation could meekly subside also. But I doubt that this will happen without a significant loosening of the labour market and a rise in unemployment.

This could occur naturally as a result of a weakening of aggregate demand, thanks to the squeeze on consumer real incomes. But I doubt that this will be enough.

Until the Autumn Statement, there was some prospect that imminent fiscal tightening would obviate the need for much higher interest rates. In the event, however, the statement’s planned tightening comes in two years’ time. Indeed, over the next two years there is set to be a degree of fiscal loosening.

Many of the very monetarists who warned of the inflation upsurge are now warning of monetary overkill because the rate of growth of the money supply has recently fallen back markedly. Some even suggest that no more rate increases are necessary at this point and that, before too long, rates will need to be cut.

I think this is wrong. The influence of the money supply on nominal demand is not that precise with regard to amount or timing. Even if monetary growth slows markedly, there is still enough money in the system to support rising prices. The labour market holds the key.

With productivity growth so low, pay inflation of 6pc will tend to produce price inflation somewhere between 5pc and 6pc or, putting the matter a different way, other things equal, if price inflation is to be sustained at 2pc, then pay inflation must be no more than 2 to 3pc. It is going to take a lot of easing in the labour market to bring that about.

The upshot, I think, is that neither the authorities, nor the markets, nor the public, have yet grasped the scale of the tightening that may be necessary to bring inflation under control.

This Thursday, the Boe’s Monetary Policy Committee will probably increase interest rates by 0.5pc, taking them to 3.5pc. But if I am right, there will still be much further to go.