The London Business School with Gower Publishing: Forecast Release: EARNINGS AND UNEMPLOYMENT IN THE CAR INDUSTRY: THE BEST AND WORST OF BRITISH INDUSTRY

The Chancellor has described the cost in terms of lost output and higher unemployment of getting inflation down as ‘well worth paying’. Yet the trade-off so far is a miserable 1.25 per cent off the underlying rate of growth of earnings for an unemployment increase approaching 600,000, some 2–3 per cent off the underlying rate of inflation for a 3 per cent drop in GDP and a 7 per cent fall in manufacturing output. The question is clear: why is it that in the UK we seem to have to pay such a high price in terms of lost output and higher unemployment to make only modest progress on reducing wage and price inflation? One possible answer is in terms of the NAIRU; another stems from the way in which we measure retail price inflation. Using the example of the car industry as a backdrop, we examine the relationship between unemployment and inflation and ask whether there is a role for government to play in improving the trade-off. Our conclusion is that the present non-interventionist stance is probably appropriate but that the government should be doing more to educate both sides of the wage bargain - a challenge picked up by the Prime Minister in his recent speech to the CBI. This is especially appropriate at the present time, because price inflation is falling but wage inflation is lagging behind. It is not a cut in real wages that is required but an equi-proportionate deceleration in both wages and prices. By joining the ERM, we will ultimately obtain German rates of inflation; low wage settlements would both shorten the time-scale and reduce the unemployment cost of convergence.     

WORLD OUTLOOK

World output, which was strengthening immediately prior to last October, appears to have barely suffered in the short term from the stock market crash. Apart from an early reaction by US consumers - since reversed - demand is proving robust and in early 1988 OECD industrial production is, we estimate, 6 per cent up on year-earlier levels, with GNP more than 4 per cent higher. Indeed such is the strength of activity that the present balance of risk is not that recession is imminent but that inflation may pick up again. In the United States, where activity rates are at their highest level for eight years and unemployment is at a fourteen-year low, monetary policy has been tightened and interest rates are moving higher. The Bundesbank is keen to follow suit and the BoJ is keeping the situation under review. Nevertheless, with wages in most countries still adjusting to the low inflation rates of the last two years, there is little evidence yet that prices are accelerating.
We expect to see world interest rates edging higher in the second half of the year as recorded inflation picks lip. But we believe that underlying inflation remains low and that, even on the assumption that oil prices return to 18 a barrel, OECD consumer price inflation will peak early next year at a little over 4 per cent. Tighter monetary policy is also expected to hold back demand over the next 12 months. Consequently, we expect some weak- ness in output in the first half of next year but discount the possibility of a severe recession. GNP growth in the OECD area is forecast to decline from the 3 per cent rate of 1987–8 to a little over 2 per cent next year and to a sustainable 2½ per cent p.a. over the medium term.     

The London Business School with Gower Publishing

Output has stagnated in the main industrialised countries this year but we expect the benefits of lower oil prices to show up in rapid growth from now on. The present weakness in the world economy stems from tighter US fiscal policy and the oil price shock itself. These have combined to reduce domestic demand in the United States, and hence to cut the market for Japanese exports in particular, and also to reduce expenditure by energydependent countries and companies. A further factor is that, with prices of oil-based products falling, there is an incentive to delay expenditure. We expect this impact effect of OPEC III to be short-lived and to give way to its positive effects in the second half of this year. Specifically, we expect consumer spending to lead the recovery as real incomes will be boosted by the terms of trade gain from lower oil prices - equivalent to 3 per cent of GNP in the OECD area as a whole. On the basis of oil prices holding at $15. we forecast OECD output growth of 3 per cent this year, rising to 41/2 per cent in 1987. Additionally, we expect lower oil prices to produce a significant reduction in world inflation. Zero growth of producer prices is forecast on average this year arid consumer price inflation is expected to fall to wards 2 per cent in the course of the year.     

The cost of living,threshold bargaining and incomes policy1

For trade union bargainers one of the infallible laws of political economy is that wages lag behind prices. This means that in an inflationary era the real value of the wage to which their members are entitled will be eroded, and some compensation will have to be made for this at the next round of wage negotiations. Therefore, changes in the cost of living since the last settlement will be regarded by trade unions as one of the most important factors to be taken into account in arriving at a new settlement. This is implicit in the statement made by the TUC in 1971 that “it requires pay increases of at least 10 per cent simply to restore the real disposable pay of a union's previous settlement 12 months earlier”. Economists, on the other hand, argue that once an inflation is under way, then economic agents will develop an inflationary psychology—that is, they will expect it to continue and will adjust their behaviour accordingly. If this is correct, trade union bargainers will attempt to anticipate inflation by trying to fix the money wage at a higher level than they would aim for if the price level were more stable.     

The paradox of rising wage growth and falling inflation

• ? Strong labour markets and rising wages in advanced economies stand in sharp contrast to recent declines in economists’ inflation forecasts and market expectations. In our view, though, these developments are not necessarily contradictory. Even if wage growth edges higher, we think demand factors will limit any pick‐up in prices. Instead, we expect firms’ margins will be squeezed.
• ? Although the labour share has risen more sharply than we had expected over the past couple of years, we are sceptical that this will translate into substantially stronger underlying inflation. Not only has the rise been small, it has been employment rather than wages that has surprised to the upside. The strength of employment is probably more about firms’ production preferences than workers’ capitalising on a stronger negotiating position.
• ? True, wages adjusted for productivity now look high by historical standards. But neither theory or empirical evidence suggests that this must inevitably lead to stronger CPI inflation in the short‐term. Our forecast for flat wage growth in 2019 and the absence of strong cost pressures elsewhere are also a comfort.
• ? Inflation tends to be more responsive to demand indicators – and the recent GDP growth soft patch suggests any further pick‐up in underlying inflation pressures will be limited (see Chart below).
• ? More generally, we think that the consensus view on inflation for the key advanced economies is high. Market‐based inflation expectations are typically lower than our own, which may reflect the perception that inflation risks are skewed to the downside. Positive economic surprises could lead downside risks to narrow, but ageing expansions and secular stagnation worries suggest this is unlikely, limiting any future pick‐up in bond yields.

     

Forecast Summary

A pause in world activity held back UK industry in the first quarter of the year and, even though we expect faster growth from now on, we forecast total output growth of only 2 per cent this year. But next year a stronger world economy and pre-election tax cuts lift growth to 3 1/4per cent. Lower oil prices and falling interest rates help keep inflation at its current level both this year and, as long as wages respond, next. In the medium term we expect the growth rate to fall back but, assuming that a fairly tight fiscal policy is pursued by whichever government is in power, we predict that inflation stays below 3 per cent     

THE REAL WAGE GAP

Over the past year a gap has opened up between the growth of manufacturing productivity and that of real wages. This gap cannot persist indefinitely, but it can be closed in many different ways. The best that can happen is that wage settlements fall while output and productivity accelerate. The worst outcome would be continued stagnation of real output and no deceleration of wages, in which case the required productivity improvement would have to come about through renewed labour shedding. There are worrying signs that this has started to happen. An intermediate solution might involve a fall in the exchange rate, with some improvement in competitiveness boosting real output (so that UK producers get a larger share of buoyant consumer spending) and some rise in prices holding back real wages.
We continue to believe that the most likely outcome is a rise in output and a fall in the rate of wage settlements. In our June forecast this occurs despite a fall in the real exchange rate. In these circumstances we expect the growth of unit labour costs to fall back from its current high level so that the current 3 per cent inflation rate becomes a true "core" rate. But a moderate fall in the real exchange rate may prove hard to achieve, especially if the oil price continues to weaken. We therefore explore what would happen if the required depreciation happens more rapidly, so that interest rates have to remain high to prevent it getting out of control. In this case we would expect lower growth and higher inflation than we forecast in June.     

WORLD OUTLOOK

The world recovery, now three years old, has proved more resilient than many expected and will be sustained in 1986 by lower oil prices. Fears that the early-1985 slowdown would turn into renewed recession have proved unfounded, as output in both the United States and Europe picked up in the second half of the year. The improvement stemmed from lower interest rates, falling inflation and weak commodity prices and was further helped by the sharp correction to the value of the dollar following September's G5 agreement. To these factors, which will remain supportive this year, is now added a lower oil price. The recovery in world output has not produced an increase in oil demand and, as the oil price rise of 1979-80 gave a further boost to supply from non-OPEC sources, a severe imbalance has emerged in the oil market. To maintain a £26 marker price (itself cut from £29 last July) has required a cutback in production of ever-increasing magnitude from Saudi Arabia in its role as OPEC's swing producer. Now that Saudi Arabia has abandoned this role in favour of stabilising its market share, oil prices have fallen sharply. We assume that the oil price will fall to £20 by the end of this year, a fall in real terms of 30 per cent. As a result the world recovery is given renewed impetus and output accelerates over the next twelve months. A cyclical peak in activity emerges in 1987, after which output growth settles at 2%-3 per cent and inflation at 4–5 per cent.     

Economic Outlook 1990–1994: The London Business School with Gower Publishing: Forecast Release: THE 1991-92 WAGE ROUND

The current wage round begins under circumstances markedly different from the previous one. A year ago the Department of Employment measure of the underlying growth in average earnings was, at 10 per cent, higher than at any period since the 1979-80 pay explosion. Following the invasion of Kuwait there were considerable dangers that cost pressures would initiate a wage-price spiral. In the event the hike in oil prices had only a small and temporary effect on headline inflation rates, which was more than offset by deflationary pressures resulting from the worse-than-expected economic downturn. In addition, UK entry to the ERM in October meant a major shift in the conduct of economic policy. The need to maintain the pound at its high central parity introduced extra discipline into pay-bargaining by ruling out the accommodation of uncompetitive wage rises through depreciation.     

Forecast Summary

Led by private sector demand, the economy has grown very rapidly in the last 12 months, Output has risen nearly 6 per cent and unemployment has fallen by over ½ million but the current account deficit has widened dramatically and wage and price inflation is increasing. Monetary policy has been tightened sufficiently, we believe, to produce a gradual reduction in the current deficit over the medium term and to prevent inflation from breaking the 7 per cent level which a higher mortgage rate will ensure early next year. But, as demand is reined back, there is a cost to output which rises 3 per cent next year, 2–2½ per cent thereafter. Unemployment continues to fall, dropping below 2 million at the end of next year and reaching 1.8 million by 1992.     

Forecast Summary

Short-term economic prospects for the UK will depend critically on what happens to oil prices and on the government's response to any changes. Our central case assumes that North Sea oil averages £20 a barrel for the remainder of the year and that the government holds the sterling index at about 74. In the Focus we also examine the sensitivity of the forecast to changes in oil prices. The willingness of the government to let the exchange rate fall in response to the fall in oil prices means that we still expect GDP to grow by about 21/2. per cent in 1986 and we expect inflation to fall below 4 per cent by the middle of the year. Lower oil prices generate a faster growth of world output; the UK benefits from this and we are forecasting growth of nearly 3 per cent in 1987 with inflation falling further.     

THE 1981 BUDGET

In this Forecast Release we examine the short-term prospects for the UK economy in the light of the Budget and other developments. Compared with our February forecast the Budget has raised taxes by about £2 bn but it has also increased public expenditure by a similar amount The net effect on the PSBR, compared with our February forecast, is therefore small, especially if the Treasury's estimates for nationalised industry profits and/or public sector wages prove over-optimistic. We therefore believe that the outturn for the PSBR in 1981-82 could be close to the figure of £12 bn presented in our last forecast.
We also believe that the prospects for output and inflation are little changed The Budget by itself will have raised prices by about 1 per cent compared with our previous forecast but because we had probably over-estimated indirect tax receipts, the net effect on prices is small For output, the likely reduction in consumers' expenditure is more or less offset by higher public spending. We continue to expect a fall in output between 1980 and 1981 of 1–11/2 per cent, inflation during the year at about 10 per cent, a current account surplus of £3 bn, monetary growth of 8 to 9 per cent and a PSBR of £12 bn.     

Tighter labour markets to finally lift global wages

• Wage growth has been relatively slow since 2007 in advanced economies, but an upturn may be in sight. Slow productivity growth remains an issue but tighter labour markets make a positive response by wages to rising inflation more likely and there are signs that compositional and crisis‐related effects that dragged wage growth down are fading – though Japan may be an exception.
• Overall, our forecasts are for a moderate improvement in wage growth in the major economies in 2017–18, with the pace of growth rising by 0.5–1% per year relative to its 2016 level by 2018 – enough to keep consumer spending reasonably solid.
• Few countries have maintained their pre‐crisis pace of wage growth since 2007. In part this reflects a mixture of low inflation and weak productivity growth, but other factors have also been in play: in the US and Japan wage growth has run as much as 0.5–1% per year lower than conventional models would suggest.
• The link with productivity seems to have weakened since 2007 and Phillips curves – which relate wages to unemployment – have become flatter. A notable exception is Germany, where the labour market has behaved in a much more ‘normal’ fashion over recent years with wage growth responding to diminishing slack.
• ‘Compositional’ factors related to shifts in the structure of the workforce may have had an important influence in holding down wage growth, cutting it by as much as 2% per year in the US and 1% per year in the UK. There are some signs that the impact of these effects in the UK and US are fading, but not in Japan.
• The forecast rise in inflation over the next year as energy price base effects turn positive is a potential risk to real wages. But the decline in measures of labour market slack in the US, UK and Germany suggests wages are more likely to move up with inflation than was the case in 2010–11 when oil prices spiked and real wages fell.

     

The impact of the COVID-19 pandemic on business expectations

We document and evaluate how businesses are reacting to the COVID-19 crisis through August 2020. First, on net, firms see the shock (thus far) largely as a demand rather than supply shock. A greater share of firms report significant or severe disruptions to sales activity than to supply chains. We compare these measures of disruption to their expected changes in selling prices and find that, even for firms that report supply chain disruptions, they expect to lower near-term selling prices on average. We also show that firms are engaging in wage cuts and expect to trim wages further before the end of 2020. These cuts stem from firms that have been disproportionally negatively impacted by the pandemic. Second, firms (like professional forecasters) have responded to the COVID-19 pandemic by lowering their one-year-ahead inflation expectations. These responses stand in stark contrast to that of household inflation expectations (as measured by the University of Michigan or the New York Fed). Indeed, firms’ one-year-ahead inflation expectations fell precipitously (to a series low) following the onset of the pandemic, while household measures of inflation expectations jumped markedly. Third, despite the dramatic decline in firms’ near-term inflation expectations, their longer-run inflation expectations have remained relatively stable.     

WORLD OUTLOOK

In the course of 1984 growth rates in the major economies came together. This reflects a slowdown in the United States, and to a lesser extent Japan, from the middle of the year and continuing recovery in Europe. This convergence is expected to continue in 1985 when total output in the OECD area is forecast to increase by 3 per cent. Within this total it is likely that the US, West Germany and the UK all achieve about 3 per cent; Japan should grow more quickly, France more slowly. In spite of a rapid recovery in output from the late-1982 trough, inflationary pressures remain weak. Measured in dollar terms, non-oil commodity prices have fallen and the oil price is under considerable down wards pressure. We expect inflation to stay at about its preset level in the US, West Germany, Japan and the UK and decline further in France, Italy and other countries where policy reaction to the 1979-80 oil price shock was delayed. In the medium term we expect the world economy to experience steady growth combined with a constant or slightly increasing inflation rate. This reflects a stable policy environment and falling real oil prices. After the excesses of the 1970s and early 1980s it is possible that the rest of the decade will experience u greater stability than at any time since the 1960s.     

The London Business School Gower Publishing

The 1989/90 payround is under way against the background of the highest rate of inflation in nearly seven years, the lowest rate of unemployment since December 1980 and a spate of industrial disputes which feature pay as a central theme. Reflecting this, pay settlements are moving higher and whole economy earnings are rising at an underlying rate of 9.25per cent, compared with only 7.5 per cent in early 1987. The obvious danger, with the labour market remaining tight, is that earnings will accelerate further, possibly into double figures. If this were to coincide with slower output growth, unit labour cost inflation would increase sharply, either threatening the government's inflation objectives or, as in 1980–81, resulting in a squeeze on profits - a hard landing. In our June forecast, we ruled out this possibility - at least as the central case - but at the same time we warned that "the main economic danger lies in this area: if wage bargainers are successful in bidding up wages to compensate for higher retail price inflation, the battle to reduce inflation could be even more protracted than our forecast suggests and output prospects too would be that much weaker". In this Forecast Release we return to this theme.     

WORLD OUTLOOK

After six years of steadily rising OECD output, fears of a significant rise in world inflation are now increasing. In the last year there has been a slight pick-up in inflation with producer prices up nearly d per cent. But prompt action by the Federal Reserve to raise interest rates before the presidential election appears to have damped inflationary expectations in the US and has given Japan and Germany an opportunity to tighten monetary policy without causing major currency fluctuations. It is also apparent that the other possible source of world inflation, commodity prices, is not a problem. OPEC over-production has ensured that the oil price remains weak and other commodity prices appear to have stopped rising after a brief acceleration at the beginning of the year. Nevertheless the major imbalances in world trade are declining only slowly and without a change in fiscal policy in the major economies it is difficult to believe that minor changes in monetary policy will be sufficient if the process of adjustment begins to falter. Despite these risks, we take a sanguine view of world prospects. Tighter monetary policy should effect a slowdown in world growth next year (already indicated by recent developments, particularly in the US) and this should be sufficient to control inflation which we expect to peak at just under 5 per cent at the beginning of next year. From 1990 onwards we see steady growth accompanied by low inflation.     

How should monetary policy respond to changes in the relative price of oil? Considering supply and demand shocks

This paper examines optimal monetary policy in a New Keynesian model where supply and demand shocks affect the price of oil. Optimal policy fully stabilizes core inflation when wages are flexible. The nominal rate rises (falls) in response to the demand (supply) shock. With sticky wages core inflation falls (rises) in response to the demand (supply) shock. Impulse response functions from a VAR estimated with post-1986 U.S. data show minimal movement in core inflation in response to both shocks. The federal funds rate rises (falls) in response to the demand (supply) shock, consistent with the predictions from the theoretical model for policy that stabilizes core inflation.     

The London Business School with Gower Publishing

Last year saw the most coordinated cyclical upturn in the world economy since the early I970s, with OECD output rising 4per cent, industrial production and world trade even more rapidly. The boom in demand, which followed five years of continuous expansion, has outstripped supply and prices have begun to accelerate. To tackle inflation, the G7 monetary authorities have tightened policy over the last year, reversing the short-lived drop in interest rates necessitated by the stock market crash. This tightening may have to go further, especially in Germany and Japan where the effects of a rising oil price and higher indirect taxes are being exacerbated by currency depreciation. Although the rise in interest rates came too late to stop inflation rising, it has beet pursued with sufficient vigour to prevent inflation from seriously breaching the 5 per cent level. It is on these grounds that we forecast a relatively soft lending for the world economy on output, with growth continuing at 2.5–3per cent, accompanied by a limited reduction in inflation which stays in the 4–5per cent range. Progress on current account balances is also likely to be sluggish: in the absence of a serious attack on the budget deficit, the US deficit is likely to stay in the region of $140bn a year.     

WORLD OUTLOOK

Over the last 12 months industrial production in the OECD area has risen by 8–9 per cent, only slightly less rapidly than in the first year of recovery from the OPEC 1 oil crisis. Much of the growth in output stems from a very rapid expansion in North America although, in the second half of 1983, output in Europe and Japan began to accelerate. We expect the recovery to be maintained during 1984 with some convergence of growth rates. For the year as a whole we are now forecasting 61/2 per cent growth of industrial production, 33/4 per cent for total GNP. By the end of 1983 the long-standing reduction in inflation had run its course and OECD consumer prices were about 5 per cent higher than a year earlier. Within the area some countries, such as France and Italy, were still reducing inflation, but this was offset by the US where inflation has been rising slowly since the summer. We expect these trends to continue in 1984, i.e. stable inflation in the OECD but accelerating prices in the US, producing in each case about 5 per cent inflation. In 1985 we are now forecasting a slowdown in the world economy. This is expected to be centred on the United States, where the problem of the Federal Budget remains to be tackled. By the time of the Presidential election the US economy will have registered two years of relatively rapid growth. This is likely to be producing upward pressure on prices and interest rates and, as a result, a pause in 1985 in the growth of output. In Europe and Japan, where output has grown more slowly, we expect the recovery to be sustained in the medium term.