Cost of living already rising as inflation takes off

US inflation has now exceeded 6%, and one quarter of US households expect inflation to exceed 9% within 12 months. In the UK, inflation is above 4% and currently expected to reach between 5% and 6% by next Spring. This will have a number of political implications – indeed, more far-reaching political implications than much recent commentary appears to grasp. 

The most obvious, and most discussed, is the cost of living aspect. Household energy bills, in particular, seem set to sky-rocket and more generally household budgets may be stretched. When households find their belts tightening, support for the governing party is unlikely to go up.

This cost of living aspect may become more severe when the Bank of England raises interest rates. People have become so used to extremely low mortgage rates for so long that even relatively modest rate rises will leave them strapped for cash. Tightening mortgage rate may also take the edge off house prices, or perhaps even lead to some falls. With lower house prices, households may feel less wealthy or have less access to borrowing against their housing equity, further stretching their financial positions.

Households facing rising prices and increased debt servicing costs, on top of incoming tax increases (such as the social care levy), and expecting further inflation rises in the future, might cut back on consumption. But they might also test another path: getting a pay rise. The end of Covid-related restrictions and increased normalization of behaviour has apparently triggered quite a significant job exodus, with over a million people shifting job in the three months to September and some 1.3 million jobs vacancies as of October. To retain staff and secure new staff in a competitive market for workers, firms may be willing to raise salaries (perhaps especially so when stricter immigration rules limit their ability to get lower-wage staff from abroad).

Increased wages may feed through into costs and thence prices, creating a second round of effects on inflation, potentially meaning the Bank of England has to raise rates more than it otherwise would have done and a repeat of the cycle (albeit hopefully dampened).

In itself, a phase of wage rises could create a feel-good factor for the government. But once workers and firms start to expect inflation rises or interest rate rises ahead and wages go up in anticipation, there is a high risk of error. A particularly well-known example of that is the pay round of 1980. Although inflation had fallen from 21.9% in May 1980 to 15.4% in October, firms and workers expected inflation to return to well above 20% and in October wage rise peaked at 22.6%. But instead of rising back, inflation then fell rapidly, down to 3.7% in May 1983. That meant workers had experienced very considerable real wage rises and so firms could afford to retain only their productive workers. Mass unemployment famously followed.

Current inflation is unlikely to approach 20%, so the scale of unemployment-inducing errors of inflation expectations is unlikely to match that of the early 1980s. But the principle remains the same. If the combination of labour market tightness and expected future inflation rises lead to firms and workers agreeing wage rises in anticipation of future inflation, there is a high risk they over-anticipate inflation, leading to wage rises that make full employment unviable. The government did remarkably well (at least in its own terms) in keeping unemployment low during the pandemic. If unemployment rises in the recovery phase that will have political consequences.

Inflation, interest rate rises and unemployment could also easily come to be attributed (rightly or wrongly) to other government policies – most obviously Brexit, or perhaps to any EU-UK trade problems that arise off the back of Northern Ireland Protocol disagreements. Once there are bad economic things around, it becomes easy to blame everything the government does for them.

Boris Johnson’s premiership has been cursed with excessively “interesting times”. Barely had Brexit got done than Covid arrived. He was doubtless hoping that the end of Covid would allow him to move on to other aspects of his own agenda rather than to respond to larger events. But rising inflation, interest rates and, perhaps, unemployment may mean he is not granted that luxury.