August 1975. Harold Wilson was prime minister. Gerald Ford had been in the White House for a year following Richard Nixon’s resignation. Steven Spielberg’s Jaws was the summer blockbuster and inflation in Britain hit a postwar peak of 27%.
Statutory incomes policy was Wilson’s response to the cost of living crisis in what now seems like a completely different world. With inflation non-existent, today’s central banks have a big decision to make. Is it safe to go back in the water and start raising interest rates for the first time since the global financial crisis and recession of 2007-09?
Some would certainly love to go for a dip. There’s nothing the US Federal Reserve would like more than to be able to announce in September than the first increase in the cost of borrowing in nine years. The Bank of England feels the same way.
The reasoning is simple. The end of ultra-low interest rates would be a sign that life was back to normal. When central banks cut their policy rates virtually to zero it was as an emergency measure. Raising rates would symbolise that the emergency is over.
The process of interest-rate normalisation, however, is taking much longer than expected. Mark Carney tested the water last month when he said the Bank would consider a rate rise around the turn of the year, but he appears to be struggling to persuade a majority of the nine-strong monetary policy committee to share his view.
Indeed, the latest set of figures on the UK labour market are an argument for Threadneedle Street to be cautious. Unemployment rose for the second month in a row, there was a fall in employment that would have been bigger had it not been for an increase in non-UK citizens in work, and earnings growth either stalled or fell, depending on the measure used.
When the latest set of inflation figures are released on Tuesday, they are expected to show no change in the cost of living as measured by the consumer prices index over the past year. Recent falls in oil and commodity prices, coupled with the cheapening of imports more generally as a results of a stronger pound, will probably mean inflation turns negative again over the coming months.
The Fed looks closer to what Dennis Lockhart, the president of the Atlanta Fed, calls “lift off”. As in the UK, however, inflation is well below target even when volatile items such as food and fuel are excluded from the calculation of the cost of living index.
As far as the US labour market is concerned, the good news is that the unemployment rate is below 6%, a level consistent in the past with the idea that rates should be heading upwards. The bad news is that the unemployment rate is distorted by people giving up their search for work, with the employment to population ratio lower than it was before the crash. Weak wage growth also suggests that demand for labour is far from buoyant.
There are arguments for higher rates. One is the risk that consumers and businesses start to assume that zero interest rates are here for good and take reckless decisions on that basis. That could lead to an overheating economy, which in turn could force central banks to raise rates. Because households and firms are mentally ill-prepared, even a modest tightening of policy would have a severe impact.
A variant on this argument is that central banks needs to give themselves headroom in the event that the global economy takes a turn for the worse. Interest rates normally go up during recoveries, providing the scope to bring them down again when a new recession looms. If rates remain at rockbottom level, central banks will have to find other ways to boost activity in the event of a new recession.
As a first resort, they would restart quantitative easing, which involves increasing the money supply in order to stimulate economic activity, even though the experience of the last downturn is that such schemes don’t provide much of a bang for the buck. There would be pressure for policy to become even more unconventional, perhaps through direct transfers of cash to consumers, were things to turn really nasty.
The Bank and the Fed have so far been unmoved by these arguments. They certainly don’t want to give the impression that the current state of affairs will last for ever, but they find it hard to justify action when inflation is so low. There is also justifiable concern that increasing borrowing costs just so they can be cut again could trigger the recession they are eager to avoid.
Consequently, policy depends on what the economy looks like from month to month. The Bank’s monetary policy committee thinks inflation will gradually increase over the next couple of years. It currently stands at zero, but Threadneedle Street thinks three-quarters of the deviation from its 2% target can be explained by abnormally weak costs of energy, food and other imports. It says this state of affairs will not last and that inflation will start to rise. Lower unemployment will also make it harder for employers to find suitable labour. That will lead to pressure for higher wages.
There has been an increase in annual earnings growth over the past year, but it would be quite a stretch to see it as the start of a wage price spiral. When inflation peaked in 1975, wages were rising at an annual rate of 30%. In June this year, average weekly earnings were £488, £9 higher than a year earlier, but no higher than they were at the end of 2014.
Stephen Lewis, chief economist at the City brokerage firm ADM Investor Services International, says: “The rise in job insecurity since the 1980s, more especially after the global financial crisis, appears to have curbed the propensity of the workforce to demand higher pay relative to any given supply/demand balance in the labour market.
“If the labour market is weak and the workforce is cowed, employers will naturally prefer to keep for the owners of the firm’s capital [often including themselves] the surplus profits generated by improved productivity.”
This smells right. In the private sector, where levels of trade union membership and collective bargaining are low, Britain now has what amounts to an incomes policy that is voluntary, to the extent that workers are prepared to sacrifice pay rises in order to keep their jobs. In the public sector, where union density is higher, an old-fashioned statutory incomes policy is in force.
But that’s the only similarity with 1975. Wages are not going to head sharply upwards, and nor are interest rates.
