Written by Garry White, Charles Stanley’s Chief Investment Commentator
The ‘cost of living’ crisis has caused a rise in industrial action in Western economies. However, central banks are keen to keep a lid on wage growth – and they have their reason.
Inflation has worried markets all year. It has risen strongly on both sides of the Atlantic getting close to 10% in most of the world’s advanced economies, including the UK and US, and is heading into double figures in a number of European countries.
The main central banks were all unsighted on this development and have spent this year scrambling to catch up with the price reality. Their one way of ending inflation is to drive up the cost of money and reduce the amount of it in circulation, slowing economies – or potentially tipping them into recession. That’s why the markets have been falling as they adjust.
China and Japan have largely ducked the great inflation, despite facing the same high energy and food prices, partly because they have followed different central bank policies, with Japan still printing money and Beijing introducing measures to prop up its Covid-scarred economy. Both countries have inflation at around 2.5%. This figure, in itself, is very elevated for Japan, which has seen inflation well below 1% for most of this century.
Unwinding past positions
The pain has been worse for markets because central banks had spent recent years deliberately forcing up the value of government bonds by creating money and buying large quantities of the new bonds for their own account. To halt the inflation, the Bank of England ended its money creation and bond buying at the end of last year. The Fed stopped its programme at the end of March 2022, and the European Central Bank at the end of June. These moves were bound to hit the price of government bonds as it removed in each case a huge buyer of this paper that had been ever present in the Covid years.
Equity markets have also fallen on the back of events in the bond markets. They responded to the news that companies would have to pay more for their future borrowing and variable rate debt. They showed concerns that the central banks, by putting the brake on economies, would reduce or slow turnover. This would ultimately lead to a squeeze on company margins and profits.
Investors asked whether the central banks might overdo their response and bring on deeper recessions. They also had to weigh up the possibility that the inflation would get worse before it got better, leading to even tougher action by the Central Banks.
Is inflation embedding?
Our base case this year has assumed that we will get to peak inflation in summer and early autumn in most of the main advanced countries. It assumes the central banks, currently in hawkish mode, will be able to slacken their ferocity as inflation starts to come down and as their forecasts of lower inflation for next year then look more credible.
Our worse cases revolved around two main possibilities. It is possible the inflation does not peak – but embeds with high wage awards chasing high prices into a self-defeating wage/price spiral. It is also possible the central banks overdo their rate rises and keep rates too high for too long, creating a deep recession. Recent events and data on the progress of jobs and wages implies these risks are subsiding a bit.
A self-defeating wage/price spiral
On both sides of the Atlantic wage growth has remained below price growth. This is bad news for many working people, who take a hit to their living standards with prices rising faster than their income. It is what today we refer to as a ‘cost of living’ crisis. Nevertheless, it is what the central banks want to happen, as it prevents companies granting staff high pay awards and funding it by raising prices on their products – which again boosts inflation in a self-defeating circle.
In the Eurozone, wages and salaries only managed to rise 2.7% in the first quarter compared with the previous year, despite inflation accelerating to 8.6% in June. Wages have been a lot livelier in the US, with hourly compensation in June 6.2% higher than a year ago. This still means people are getting worse off as it is below the level of price inflation.
There are issues over how to account for bonuses and other rewards. There are numerous cases in sectors short of labour of so-called one-off payments not incorporated into the underlying salary or wage rate to retain people and help employees. Were these to be consolidated into the figures and to be continued next year there would be a bit more wage inflation to account for. Germany, with above-average wage growth in the Eurozone, has also seen a number of special bonuses in response to a tight labour market.
US employment is at a new high of 160 million. There are still 5.9 million unemployed, a low rate of 3.6%. Meanwhile, the rate of adult participation in the workforce – at 62.2% – is still below its level of the eve of the Covid-19 lockdowns, when it stood at 63.4%. There are people who have disappeared from the workforce and are not seeking work, adding to the shortages of available labour and leading to some higher wage rises in stretched sectors.
The European Union has seen its unemployment come down to 6.1%, a low figure compared to its past performance. The vacancy rate at 3.1% is also high compared to history. Employment in the Eurozone has reached a new high of 162 million.
A close eye on labour markets
So far, there are no signs of a further upwards surge in wage and salary rates. There may well now be some slackening of the pace of new vacancies, as most places have unlocked from pandemic-related restrictions and the summer season in the northern hemisphere is well advanced.
The hotels, travel companies and restaurants that can capture the summer trade have now largely recruited as much as they can for the holiday period. There could also be some increase in the numbers of people wanting a job. Those who decided to take an additional course in higher or further education during lockdowns will now need to find employment.
Some of the mothers and fathers who decided to spend more time at home without a full-time job whilst their partner went to work every day may feel the need to work longer hours to pay the rising family bills. Some people who took early retirement may find they miss the workplace or discover their pension does not go far enough and be back looking for paid duties.
This means it seems likely the labour market will now start to loosen up, offering employers more choice of candidate in the roles they wish to fill.
We will continue to watch labour markets very carefully as each month updates us on wages, bonuses, vacancies, availability for work, unemployment and jobs trends. To get through the current sharp adjustment more quickly, with fewer long-term scars, we will need more confirmation that we have avoided a nasty wage/price spiral that would force the central banks to the ‘big recession’ option to end the inflation. Taming inflation is now a priority ahead of economic growth.