Stephen King: Oil spike may not trigger higher inflation

The underlying reason for all of this angst is the rise in oil prices. People believe - almost as an act of faith - that higher oil prices lead to higher inflation. Those with long-enough memories can recall the nasty experiences of the Seventies and early Eighties. Those without can simply ask their parents. Economics, particularly of the macro kind, may be full of uncertain relationships, but the link between oil prices and inflation is, apparently, immutable.

And the evidence in favour of an inflationary shock is seemingly accumulating. Headline inflation rates have been rising through much of this year. In the US, where gasoline prices have spiked over the past couple of months, inflation threatens to rise beyond 4 per cent when the September data is released this week. No wonder our central bankers are nervous. They have been fighting a good fight against inflation for many years. Surely they are not suddenly going to have to beat an ignominious retreat?

In my view, much of the talk about a return to a period of sustained, and unwelcome, inflationary pressures is overdone. The anxiety is explicable but, I suspect, not likely to be borne out by subsequent events. To understand why, it's worth thinking about the precise implications of higher oil prices.

Other things being equal, to use the economist's favourite get-out clause, a rise in oil prices makes oil consumers worse off. Most Western nations are oil consumers. Even the UK is an oil consumer, with its North Sea production no longer sufficient to meet domestic energy needs. To make people worse off, either prices have to rise relative to incomes or, alternatively, incomes have to fall relative to prices.

This, however, is a relative adjustment between the price level and the level of incomes: the story implies no persistent increase in both prices and wages and, without that, inflation need not be an automatic consequence of a rise in oil prices.

A higher oil price means a higher import bill. A higher import bill requires more exports to balance the books. More exports imply less domestic consumption. And domestic consumption will only slow if, collectively, we are made worse off than before.

What we have seen so far this year looks more like a one-off rise in the price level. This rise might look, feel and smell like the beginnings of an inflationary process but unless there is a subsequent wage response - and there hasn't been one so far - it's difficult to believe that we are about to return to the bad old days of the Seventies. We are just being made collectively worse off as a result of higher energy prices.

So where does inflation enter the equation? In the light of an oil price shock, a subsequent sustained period of inflation should be regarded as a destructive device of income redistribution, a mechanism by which some people can safeguard their spending at the expense of others.

Imagine that society is made up of workers (who belong to unions) and enfeebled pensioners. Imagine also that the pensioners are fewer in number than the workers and, therefore, have little in the way of political clout. Then imagine there's an oil price shock. At first, everyone loses out: prices rise relative to incomes and spending power falls away.

Suppose that the unionised workers believe that, with a bit of a push, they can force through wage increases. These higher wages mean that workers are compensated for the rise in the price level. Companies, in turn, decide to raise prices. Who loses out? The answer, of course, is the pensioners. Stuck on fixed-nominal incomes, they have no ability to compensate themselves for rising inflation. As a result, the increase in the price of energy hits them particularly hard. In this story, the gains in prices and wages lead to those on wage incomes winning relative to those on non-wage incomes.

This is a cruel result, but a result that necessarily follows from allowing wages to rise in response to higher energy prices. Inflation leads to an arbitrary shift in the degree to which some members of society suffer relative to others in the face of a given cost shock. By redistributing income, higher inflation is a grossly unjust way of shifting the burden of economic pain to those who have the weakest bargaining positions in society.

And this is why I suspect that inflation will not rise very far, nor will it be sustained. Society has changed. Western populations have aged. Those people who managed to extract wage increases in the Seventies and early-Eighties are now in their 50s, 60s and 70s. This is the baby-boomer generation, the generation that, because of its numbers, has enjoyed an unusually large influence on political and economic choice.

This is the generation that, in the Seventies, was prepared to tolerate higher inflation but, by the Nineties, was pushing for independent central banks with inflation targets. Now that they have their pension nest eggs, the last thing the baby boomers want is a return of inflation.

Politics have also changed. In the Seventies, capital didn't move around the world very easily. Workers could hold their companies to ransom, threatening strikes unless inflation-busting wage increases were delivered on a plate. Now, with the collapse of communism in central and Eastern Europe, and with a more open relationship with China and India, capital has become mobile. If workers misbehave, capital goes elsewhere. Workers are, therefore, resigned to the fact that higher energy prices will not be offset by bigger wage increases.

And technologies have changed. When capital heads off to distant shores, it can be more easily managed, and the workers who use the capital can be more easily connected with the rest of the world. The collapse in telecoms charges, for example, has enabled a new supply of Indian labour to offer its services to the Western world.

Put another way, the momentous changes of recent years suggest that an oil shock now hits workers much harder than might have been the case 30 years ago.

Inflation is likely to become a persistent problem in the light of an oil price shock only if central banks do not enjoy their independence and if labour is strong enough to pass the costs of adjustment on to other members of society.

Neither of these conditions exist today. The chart, for example, shows that UK average earnings growth has hardly moved in recent years whereas, in the Seventies and Eighties, big increases in oil prices were automatically followed by big increases in wages. Of course, this means that workers suffer as a result of higher oil prices. But that's life. So long as inflation remains low, the arbitrary creation of winners and losers in the light of an oil price shock should be avoided.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com