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.     

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.     

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.

     

Executive Summary

Our assessment of the outlook for the UK economy over the next two years has become slightly more cautious in the wake of the additional fiscal tightening announced in the November Budget. Although we had anticipated tax and public spending measures of the right magnitude in 1994/95, the Budget was more severe in 1995/96 and beyond than we had expected. We have scaled back our estimates of growth for 1995 and 1996 accordingly. On a more positive note, we expect the outlook for inflation to be better than we indicated last October. The mid-1990s are' likely to see a period of sustained low inflation which has not been seen since the 1960s. The government's target measure - RPI excluding mortgage interest - is not expected to test the 4 per cent target ceiling though it is stuck in the 3-3.5 per cent range for most of the forecast period. Despite expecting slower growth, we are now more optimistic about unemployment, which we expect to fall below 2.4 million in 1997. We now believe that increased labour market flexibility should allow the economy to grow on a lower real wage and productivity growth path, at least while unemployment remains so high. However, whether this improved performance would allow the UK to sustain an unemployment of below 2 million without a serious resurgence of inflation is still open to question.     

The London Business School with Gower Publishing

This forecast release examines the latest monthly indicators. In general they are in line with the detailed forecast published in February; retail sales have recovered from the fall in 1977 and price inflation is firmly in single figures, whilst output is showing only slight signs of recovery. The most disturbing indications are for money supply and the exchange rate. Monetary growth has been above the limit and the exchange rate has drifted in a manner that we did not expect until later this year. These indicators are related and give a clear warning for the Budget strategy. Unless the rate of monetary growth is brought back below 12 per cent it will not be possible to maintain a stable exchange rate. The target of maintaining single-figure inflation would then be virtually impossible.     

The London Business School with Gower Publishing

The current economic outlook is dominated by fears of continued industrial unrest and uncertainty regarding wage increases. The key issues for output and expenditure will be the outcome of the almost inevitable conflict between the monetary objectives and wage inflation. The most recent indicators provide some evidence of the type of problems the economy will face during 1979. The figures for industrial output and consumption suggest that, by end of 1978, the growth of output was slowing down and the figures for wholesale and retail prices suggest that inflation was picking up. Adherence to the monetary targets is already, on a short-term basis, requiring little or no growth in the real money supply and accompanying high interest rates. The latest official longer-term indicators also point to a slowdown in domestic demand.
Inflation would probably have increased by now had it not been for the recent tight monetary policy and the resulting stability of the exchange rate. We have earlier argued that earnings increases of about 12% will be consistent with the current financial background. But earnings increases of 15% or more will put extreme pressure on the company sector and would bring into sharp focus the choice between finanacing wage increases and letting the exchange rate fall with resulting higher inflation rates: or holding the monetary targets and accepting the short-term consequences for output and unemployment.     

POST-BUDGET ASSESSMENT AND ANALYSIS OF OIL PRICE CHANGES

In this Forecast Release we update our February forecast to take account of the Budget and other new information, particularly about oil prices and the exchange rate. This updated forecast is then used as the basis for a set of three simulations in which we explore the consequences of lower oil prices, a fall in the exchange rate and a tightening of fical and monetary policy. The main conclusions are first that the Budget (the contentr of which we broadly anticipated) has not significantly changed our assessment of the short-term prospects for output and inflation. However, a detailed examination of the Government's revenue and expenditure estimates suggests that fiscal policy in 1983-4, though broadly in line with the Medium-Term Financial Strategy, has been loosened compared with 1982-3 by rather more than appears from the PSBR projections. We ako believe that there is a risk that the PSBR will be significantly higher than officially forecast in 1983-4.
Our simulations show the size of the PSBR overshoot in the event of a further sharp fall in the oil price. I f this were accompanied by a fall in the exchange rate, inflation would quickly be back in double figures. Whether the exchange rate falls or not a lower oil price gives significant output gains. However, if the authorities reacted by tightening fiscal and monetary policy, inflation would be broadly the same as in the Post Budget forecast, but there would still be output gains from the lower oil price.     

Wage trends and policies in China: dynamics and contradictions

This article considers the central dilemmas of wage policies in state socialist economies. It reviews the pre-1978 Chinese low-wage and high employment policy and details the development of Chinese wage policies during the 1980s. The dynamics and contradictions which have resulted in inflation, declining labour productivity, falling real wages and social tensions are analysed.     

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     

Can Germany save itself from negative rates?

• German inflation looks set to rise in response to diminishing slack in the economy. But this will be a mixed blessing for those in Germany hit by negative policy rates and ECB asset purchases. Higher German inflation may eliminate the need for further ECB policy action, but it is unlikely to trigger imminent rate hikes. As a result, the rise in inflation will merely lower real interest rates for German savers.
• Structural cross‐country differences mean that the ECB is better able to hit its inflation target when the peripheral economies rather than Germany are the region's growth engine. A key reason for this is that the German Phillips curve is flat by Eurozone standards, meaning that policymakers need to work hard to generate sufficient inflation in Germany to offset sustained weakness elsewhere.
• Despite this, there is evidence to suggest that the tightening labour market is beginning to push German wage growth higher. And if productivity growth remains subdued, this will lead to faster unit labour cost growth.
• While firms could respond by lowering their margins, the strength of household spending suggests that firms may be more inclined than in the past to pass on higher costs to consumers.
• In all, we expect German inflation to rise more sharply than elsewhere to around 2% in 2017, meaning that the ECB will not unveil further unconventional policy support. But it would take much sharper rises in German wage growth and inflation than in our baseline forecast to prompt the ECB to bring forward interest rate rises.

     

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.

     

How low can U go?

• ? Although there is growing evidence that wage growth is building in response to low and falling unemployment in the advanced economies, there is scope for unemployment rates to fall further without triggering a pay surge.
• ? For a start, current unemployment rates in comparison to past cyclical troughs overstate the tightness of labour markets. Demographic trends associated with the ageing ‘baby boomer’ bulge have pushed down the headline unemployment rate – unemployment rates among older workers are lower than those of younger cohorts. And in a historical context, Europe still has a large pool of involuntary part‐timers.
• ? In addition, rising participation rates mean that demographics are less of a constraint on employment growth than widely assumed. In both 2017 and 2018, had it not been for increased activity rates (mainly for older cohorts), unemployment would have had to fall more sharply to accommodate the same employment increase. We expect rising participation rates to continue to act as a pressure valve for the labour market.
• ? Finally, unemployment rates were generally far lower during the 1950s and 1960s than now. If wages stay low relative to productivity, as was the case during that prior era, employment growth may remain strong, with unemployment falling further. In the post‐war era, low wages were partly a function of a grand bargain in which policy‐makers provided full employment in return for low wage growth.
• ? There is evidence to suggest that many post‐crisis workers have opted for the security of their existing full‐time job and its associated benefits despite lower wage growth, rather than change job and potentially earn more; the rise of the ‘gig economy’ has led some workers to value what they already have more. Put another way, the non‐accelerating inflation rate of unemployment (NAIRU) has fallen. So, the role of labour market tightness in pushing wage growth higher may continue to surprise to the downside.

     

COMPETITIVENESS WITHIN THE EURO AREA: THE PROBLEM THAT STILL NEEDS TO BE SOLVED

Unsustainable public debt, low competitiveness and high current account deficits are major problems for the so‐called PIIGS countries. These countries experienced consumer price and wage inflation above the euro area average in the first decade of the euro, basically fuelled by buoyant capital inflows. The resulting real appreciation against low‐inflation countries led to a deterioration in their competitiveness, but rigid labour markets now prevent a quick market‐based readjustment of real wages to the changed situation. Thus, both public expenditure cuts and structural labour market reforms are urgent to reduce the likelihood of a euro area break‐up.     

A dynamic econometric model of agricultural wage determination in Bangladesh

Economists applied data from 1949-1950 and 1980-1981 to a new dynamic model to examine the dynamics of determinants of agricultural wages in Bangladesh, particularly the effect of changes in relative prices of rice (the staple food) and productivity. Just a 20% rise in the price or rice was passed on in the agricultural wage rate within the current year. About 50% was passed on in the long run, however. Therefore an increase in the price of rice reduced the rice purchasing power of agricultural wages in the short and long term. In fact, the importance given to rice in the long run real wage rate was almost the same as the mean proportion of expenditure that an agricultural laborer in Bangladesh committed to rice and closely related food staples. Thus arise in the price of rice in comparison to other goods had limited effects on the long run real wage in terms of the bundle of goods typically consumed, but very adverse effects in the short run placing a high burden on the rural poor. On the other hand, the long run real wage rate fell considerably between the mid 1960s-early 1980s when overall agricultural productivity increased. The economists pointed out that this increased productivity may not have lowered long run real wage rates, but instead mitigating factors may have contributed to this fall. For example, population growth, rising landlessness, and insufficient economic growth in nonagricultural sectors resulted in a consistent growth in the labor supply. In conclusion, this new dynamic model showed that Bangladesh cannot depend only on agricultural growth to reduce the poverty of farmers.     

The London Business School with Gower Publishing

Last year earnings growth fell below the lowest rates of increase experienced in the 1980s. At the time this was seen as primarily the result of the deflationary squeeze produced by ERM membership. It was too early to proclaim a new era of responsible wage bargaining until the recovery had occurred. Since then not only has sterling lost its E m anchor, and suffered a sharp depreciation, but an upswing in activity has also been established. However, in spite of the revival in potential inflationary forces, earnings growth has continued to decelerate in 1993. It is clear that the last recession has had a more pronounced effect on nominal wages than its predecessor. In terms of real wages, however, there appears to have been little change, implying that the fall in nominal wages is due solely to lower price inflation. The important question for the present pay round is how will the labour market respond to the recovery? Have the supply-side policies pursued in the 1980s had a decisive effect, allowing the UK to make the transition to low, stable inflation rates in the 1990s? Or will there be a reversion to traditional inflationary practices?     

A New Keynesian model with staggered price and wage setting under learning

This paper provides a study of the implications for economic dynamics when the central bank sets its nominal interest rate target in response to variations in wage inflation. I provide results on the existence, uniqueness, and stability under learning of rational expectations equilibrium for alternative specifications of the manner in which monetary policy responds to economic shocks when nominal rigidities are present. Monopolistically competitive producers set prices via staggered price contracts, and households set nominal wages in the same fashion. In this setting, the conditions for determinacy and learnability of rational expectations equilibrium differ from a model where only prices are sticky. I find that when the central bank responds to wage and price inflation and to the output gap, a Taylor principle for wage and price inflation arises that is related to stability under learning dynamics. In other words, a moderate reaction of the interest rate to wage inflation helps to avoid instability under learning and indeterminacy.     

Forecasting the Real Exchange Rate

This brief examines the historical relationship between exchange rates and relative inflation rates for a group of major industrial countries. It establishes the concept of the ‘real exchange rate’ and the ‘productivity-adjusted real exchange rate’ (PARE) as essential in understanding these relationships and projecting them into the future. It puts the discussion into the context of company decision making, as one important factor in the rate of return likely to accrue from different methods of supplying an overseas market. Differences in productivity between countries explain the divergences in prices of ‘non-traded goods’. To give a simple example, a haircut costs much more in New York than in Madrid since high US wages reflect high productivity which does not apply in many parts of the service sector. These differences rule out the acceptance of the over simple ‘purchasing power parity’ approach which assumes that exchange rates will settle at a point where all prices (in terms of a common currency) are the same everywhere, or move together. Even after account has been taken of differences in productivity growth, productivity-adjusted real exchange rates (PARE) - though reasonably stable - can still show some deviations, or ‘blips’. The ‘blip’ may occur because of rapid changes in the actual exchange rate or in domestic prices, in which case it is likely to prove temporary and the PARE rate will tend to adjust back to its normal level. But it may come from major structural changes, in which case PARE will be altered permanently within definable limits. A way of recognising the different categories of ‘blip’ is suggested in the brief. The PARE framework is then used to provide a guide to UK businesses who are concerned to calculate the future sterling value of foreign currency sales or, more generally, to estimate their competitiveness in supplying specific export markets. (The method used would apply equally well to other countries.) This is done by showing step-by-step the forecasting procedure to compute sterling's effective exchange rate to 1981 on assumptions concerning respective rates of inflation, monetary policy and the impact of North Sea oil. The computation shows that a sustained period of exchange rate stability is possible for the UK, even if UK inflation rates remain significantly above the world level for the next two years.     

Educational mismatch,wages, and wage growth: Overeducation in Sweden, 1974–2000

We examine the impact of educational mismatch on wages and wage growth in Sweden. The empirical analyses, based on cross-sectional and panel data from the Level of living surveys 1974–2000, are guided by two main hypotheses: (a) that educational mismatch reflects human capital compensation rather than real mismatch, and (b) that educational mismatch is real but dissolves with time spent in the labour market, so that its impact on wages tends toward zero over a typical worker's career. Our findings do not support these hypotheses. First, significant differences in contemporaneous economic returns to education across match categories remain even after variations in ability are taken into account. Second, we find no evidence that the rate of wage growth is higher among overeducated workers than others. Our conclusion is that the overeducated are penalized early on by an inferior rate of return to schooling from which they do not recover.     

Planning Feature The Forecast in Detail: [4] Focus: Unit Labour Costs in Manufacturing Industry and the Outlook for Price Inflation

The latest figures show that unit labour costs in manufacturing rose 8.9 per cent in the year to March, the highest rate of increase since 1981 (when costs were decelerating) and a sharp contrast with 1983 when, for a brief period, COSD were stable. In this Focus we examine how this development has occurred and consider its implications. We conclude that the recent figures represent a temporary deterioration in the costs of manufacturing industry and that, once output picks up again and as long as wages respond to the current low rate of inflation, there should be no severe adverse consequences on either inflation or output. If, however, costs are not controlled then the outlook for either inflation or output and unemployment is worse than our central forecast suggests.     

Monopsonistic competition for the “best” workers

In this paper we analyse an economy where firms use labour as the only production factor, with constant return to scale. We suppose that jobs differ in their non-wage characteristics so each firm has monopsonistic power. In particular, we suppose that workers are heterogeneous with respect to their productivity. Then, each firm has incentives to offer higher wages in order to recruit the most productive workers. Competition among firms leads to a symmetric equilibrium wage, which is higher than the reservation wage, and to involuntary unemployment for the less productive workers, who are willing to work at the current wage but are not hired because their productivity is lower than the wage level. If firms have no institutional constraint on paying lower wages for the same job, an endogenous labour market segmentation emerges.