The economic landscape in the UK is currently on a tense roller coaster ride, a situation that Andrew Bailey, Governor of the Bank of England, had been predicting for over a year.
The United Kingdom, he asserts, has fallen into a pernicious wage-price spiral despite twelve consecutive central bank interest rate increments aimed to control the situation.
The makings of UK’s wage-price spiral
Bailey, in his recent address, spoke of the persisting core inflation as a byproduct of higher energy prices. However, he placed particular emphasis on the “second-round effects”, a phenomenon that emerges when external shocks intertwine with the domestic economy’s current state.
As headline inflation decreases, these second-round effects, which include domestic wage growth and price setting, persist longer than initially expected.
The wage-price spiral theory is now in action, whereby increased inflation leads workers to negotiate for wage hikes. This, in turn, fuels demand, pushing companies to raise prices to counteract their escalating expenses.
As a result, the cycle continues with workers necessitating higher wages to afford goods and services.
The domino effect on inflation and wages
Interestingly, the UK inflation rate remained steadfast, exceeding 10% in March, which caught economists off-guard. Core inflation, which excludes food, energy, alcohol, and tobacco, maintained the previous month’s rate of 5.7%.
Bailey pointed out that the labour market’s relaxation, manifested through dwindling job vacancies, has been more gradual than anticipated by the central bank.
Both nominal wage growth, unadjusted for inflation, and services price inflation happened as per the bank’s forecasts. While the Bank of England discerns signs of wage growth slowdown, it also observes that services inflation remains high.
The monetary policy committee remains vigilant, deeming the risks to inflation as tilted significantly to the upside, and assures to regulate its main bank rate as required to attain its 2% inflation target.
Bailey had previously advised businesses to exercise restraint in pay negotiations and suggested that workers should avoid demanding substantial pay raises.
These comments faced criticism as the public grappled with a cost-of-living crisis, driven by inflation causing sharp wage growth decline in real terms.
The UK’s unique challenge
Unlike the EU and the US, where economists and policymakers no longer foresee a significant risk of a wage-price spiral due to salaries catching up with inflation, the UK faces a different set of circumstances.
Alberto Gallo, Chief Investment Officer at Andromeda Capital Management, singled out the UK as the developed economy most susceptible to a wage-price spiral, citing factors such as the British pound’s frailty, dependence on food and energy imports, and a constricted labor market post-Brexit.
The Bank of England’s chief economist, Huw Pill, also stirred controversy last month, suggesting that the UK needed to accept the reality of a collective economic downturn.
According to Pill, workers and companies need to cease escalating prices, whether through wage hikes or passing on energy costs to customers.
Despite these challenges, the Bank of England remains vigilant, ready to make necessary adjustments to maintain economic stability in the UK. As the economic landscape continues to fluctuate, the careful monitoring of the wage-price spiral and its potential impacts remains vital.
