Last year, the MPC warned that interest rates would have to rise if inflationary expectations became detached from the 2% target. In the June Citigroup / YouGov survey of households, the median forecast for inflation over the next 5-10 years rose to 4.1% – the highest in the survey’s five-year history.
More recently, MPC members have focused on pay trends rather than inflationary expectations as a possible trigger for policy tightening. For example, in a submission last month to the Treasury select committee David Miles said, “There is little evidence that any rise in inflation expectations has led to higher wage growth. Without a pick up in wage inflation I do not think it likely that inflation being significantly above target is sustainable.”
Private-sector regular earnings (i.e. excluding bonuses) rose by 2.6% in the year to May – the largest annual increase since January 2009. Growth averaged a slower 2.1% over the last three months but was depressed by the additional April bank holiday, which resulted in a fall in average weekly hours compared with a year ago (the earnings figures measure weekly pay). The 2.6% May increase, therefore, is probably a better guide to the trend.
The median private-sector pay settlement has fluctuated between 2.5% and 3.0% in recent months, according to Incomes Data Services. Under normal circumstances, annual growth in regular earnings is higher than a 12-month moving average of settlements, reflecting “pay drift” – the additional boost to wages from progression, interim adjustments and restructuring outside the annual review. Pay drift was running at 0.3 percentage points in early 2011 and averaged 0.6 pp over 2001-07, according to the Bank of England (May Inflation Report, p.37). Assuming no further change in settlements and a firming of pay drift in response to better second-half economic performance, private earnings growth could rise to 3.0-3.5% by early 2012.
Historically, earnings growth of 4% has been viewed as consistent with the 2% inflation target based on trend productivity (output per hour) expansion of 2% per annum. Productivity performance, however, has weakened and trend growth may now be 1.5% or less, as explained in a previous post. With the low level of sterling maintaining upward pressure on import prices, moreover, domestic unit labour costs probably need to rise by less than 2% pa for the inflation target to be met.
A rise in private-sector earnings growth to 3.0-3.5%, therefore, ought to ring inflationary alarm bells even among the MPC’s doves.
