For most of the last five years, the financial community has fretted that inflation was about to enter upon a vicious circle of esculating commodity costs, quickening consumer prices and sympathetically higher pay settlements.
That’s what had happened in previous oil shocks and it’s what the consensus had expected the consequence of the latest surge in raw material prices to be
In the event, though, the anxieties proved to be unfounded. Even when economies were growing most quickly (in 2005 and early 2006), there was no significant leakage from prices to pay deals. Instead, nominal wage increases proved to be upwardly sticky, with the result that personal real spending power weakened progressively.
But what might happen now that commodities costs are in retreat again? Will pay rises persist at current levels, causing real wages to improve? Or will the former subside in parallel with a moderating pace of consumer prices, adding to the latter’s downward momentum?
The consensus, inclined to be pessimistic about inflation, is apparently unfussed by its chronically inaccurate track record in recent years. It still sees the potential for a pay explosion as a clear and present danger. Soft commodity prices notwithstanding, pay deals are going to be resistant to moderation, it claims.
Probably not. Even if the world had not lurched into recession, it’s unlikely that wage deals would have stayed at current levels – the bargaining position of labour having become so weak. But, now that activity is declining, now that unemployment is soaring, there is almost no chance of settlements holding up. They’ll moderate and they’ll do so almost immediately. The consequences are straightforward: consumer spending power will stay depressed, and inflation will tumble.
The maths is simple. Commodities represent approximately 6% of total costs. Accordingly, if consumer prices have been rising by 4% a year at a time when raw material prices were climbing by 25% pa, it’s clear that the underlying trend in inflation (that caused by non-commodity considerations) has been quite low – of the order of 2.5 % pa.
If raw material prices should now fall for a spell at an annual rate of 30%, consumer prices would, if only temporarily, rise at a rate of just 1% a year. And that, before any account had been taken of softening pay rises. If the latter were to slacken at half (say) the pace of consumer prices, there’d be a moderation in settlements amounting to 1.5% – from 3.5% to just 2%. And that would knock another 1% off consumer inflation – taking it down to zero.
Of course, commodity prices would not continue indefinitely to fall at an annualised 30%; at some stage, there’d be a much slower decline or even a resumption of stability. But, if the near-term slide were to be sufficiently steep for sufficiently long, it could institutionalise negligible (or negative) CPI inflation – as it did in the 1930s. Pay deals would be the pivotal consideration. If they were to keep softening, partly because of low inflation in the past, partly because of rising unemployment, the chances are that inflation would keep falling in the future.
That’s what has happened in every other phase of excess supply. There are examples of it in the 1930s; in the 1870s; and it happened in Japan in the years after 1990.
The implications for pensions contributions are obvious enough. Those for defined contribution (DC) schemes would be set to suffer particularly sharply. Their growth, reflecting salary progression on the one hand, employee numbers on the other, might stall. A couple of years hence, many might be sustaining modest declines.
Defined benefit (DB) schemes are more complicated. If they are to survive in their current form, assets being kept in line with liabilities, they’ll need huge additions to contributions. And thereby hangs the tail. Today, DB is reserved almost exclusively for the pampered employees of the public sector. Can so generous a deal be sustained for them in a period of economics adversity? Probably not. Private sector workers, the creators of community wealth, do not want the product of their labour squandered on those who, they believe, contribute very little to national well-being.
Gordon Brown retreated at the time of his last confrontation with public sector unions. He’ll have to be made of sterner stuff next time. Failing that, the elimination of the anomaly will have to await an election of a new government.
One way or another, though, the public sector’s excesses will be culled, and the drain occasioned by DB provision staunched. Either the schemes will be closed or their benefits redefined. The retirement age for functionaries, for instance, might be raised to 70 – a reflection of the undemanding nature of most employment. In any event, pensions contributions will be scaled back. It’s not sensible or desirable that, in a period in which living standards everywhere are to be squeezed, huge sums be wasted. There’s no point in saving for future retirement if present circumstances are barely survivable!