Stagflation fears require firm action to quell panic

To steal from Ernest Hemingway, there are two ways for an economy to go into stagflation – gradually and then suddenly. The odds of this awful portmanteau word – a combination of stagnant growth and inflation – becoming a reality have risen sharply in the last few weeks.

Prices of raw materials, fuel and supplies for factories among many other goods risen sharply, thanks to supply chain bottlenecks and labour shortages.

The Bank of England warned in August that inflation would rise to 4 per cent by the end of this year, but last week its governor, Andrew Bailey, added to the warning, saying developments since then meant inflation was likely to rise to further above that level.

So far, so gradual. Prime minister Boris Johnson is clearly buying into that story, saying that the economy is going through a “transition” from a low-wage, low-productivity economy reliant on cheap labour from overseas to a higher-wage, higher-productivity model.

The headlines have focused on a shortage of hauliers, fruit and vegetable pickers, and qualified butchers, which can be blamed on our disorderly Brexit transition.

But the impact is wider. The snapshot survey of the construction industry by IHS Markit and the Chartered Institute of Procurement & Supply last week revealed another growth slowdown in September thanks to transport disruptions and a severe lack of materials as well as continued staff shortages.

Their survey of the services sector, which makes up four-fifths of the economy, blamed staff shortages and supply issues for a surge in inflationary pressures to their highest for at least 25 years.

To plug the gap, employers are having to put up wages. The headline growth rate of average earnings came in at 8.3 per cent in July – down from 8.8 per cent in the previous month but still way ahead of inflation. Meanwhile underlying pay growth is estimated to have risen from a range of 3.5-4.9 per cent in June to 3.6-5.1 per cent in July, although the national statisticians are aware of Covid-related distortions.

While rising wages are good news for workers, there are four caveats. Firstly, these gains are not evenly spread. As Bailey pointed out in his speech, the “dispersion” of pay growth has risen quite markedly – in other words for every headline-grabbing high pay rise, there is another low one.

Secondly, firms are under increasing pressure to pass those costs onto other businesses and consumers in the form of higher prices, which will eat into any wage rises.

Third, this comes as growth too is showing signs of vulnerability. Economic activity increased by just 0.1 per cent between June and July, causing a number of City economists to pick up a “whiff of stagflation”.

Finally higher wages are only sustainable if workers are more productive, delivering more output per hour worked. Yet productivity growth has stagnated since the Conservatives won power in 2010.

Taken together, these uncertainties are fuelling worries that inflation could persistently overshoot central banks’ targets and lead to expectations of yet higher inflation to come, leading to a self-fulfilling spiral.

Worries will be compounded when the International Monetary Fund releases its keenly anticipated World Economic Outlook on Tuesday. In a pre-release last week, it published analysis showing inflation in advanced economies could jump as high as 12 per cent were expectations to become “de-anchored”.

The IMF’s fear is that people lose faith in policymakers’ ability to bring inflation back to target, at which point expectations over future price rises become unmoored.

Financial markets are clearly getting het up over the stagflation fear with UK’s index-linked bonds now implying that inflation will be around 7 per cent in April next year.

Kallum Pickering, an economist at Berenberg Bank, says it begs the question why the UK “once again” seems to be getting hit harder than other economies. He puts it down to a growing lack of public confidence in the government’s ability to fix problems when they arise.

Against that backdrop, any measures by the prime minister to “prenez un grip” to train workers in the UK to fill gaps in the skilled labour market while incentivising others to take up jobs they previously turned their noses up at would be positive.

To deliver high-wage, high-productivity growth, substantive policy action rather than sloganeering and infighting is needed to make those wage rises sustainable sooner rather than later – or suddenly rather than gradually as Hemingway might have put it.