Understanding inflation and the need for long-term investment

This article first appeared in the UCL Policy Lab Magazine. 

A series of strikes have hit British commuters in the past few months. Railway workers have been leading walkouts over jobs, pay and working conditions. Over 40,000 RMT members from Network Rail and 14 train operating companies have taken to picket lines, effectively shutting down the railway network as negotiations between the union and rail industry have reached an impasse. 

During these arguments, many in the government and the Bank of England contest that we cannot raise public pay packets as the unions want because we would go into a “pay spiral” so that inflation is out of control.

The trade unions, in contrast, argue that the cause of rising inflation is escalating company profits. How may we best understand the economic arguments that inform these two claims?

Pay at a time of high inflation  

Let's start with the pay spiral that the government refers to—commonly known as the wage-price spiral. It describes the phenomenon by which prices increase due to higher wage demands due to a rise in inflation expectations. When employees expect inflation to rise, they demand an increase in the nominal wage. The wage rise effectively increases business expenses and can be passed on to the consumer as higher nominal prices. Seeing the rise in prices, the employees will further ask for wage increases, leading to further rises in prices passed on by the business.

It is a potentially perpetual cycle of consistent price increases. Many theories suggest that active monetary policy is necessary to curb this wage-price spiral. But there could be market built-in stabilising forces too.

In truth, how the spiral starts is not entirely clear.

A common belief is a sudden increase in demand for goods and services that are not easily met by supply. Also, a sudden reduction in supply can make demand look excessive.

Impact of the pandemic

Dramatic fiscal and monetary measures -- of the sort seen during the pandemic––can generate a rise in aggregate demand. These measures can be vital. During the pandemic, we needed them to mitigate the demand drop that resulted from the health measures used to combat the pandemic crisis.

The consequences of these restrictions can also prevent supply from adjusting quickly.

For example, airlines quickly stopped contracting with experienced pilots in 2020 as part of their pandemic response measures. But it is expensive and time-consuming to train pilots, leaving pilots who opted for early retirement sitting pretty while their former employers scramble around to find their replacements. Similar supply issues are present in other sectors.

Given this, it might not be surprising to see overall double digits inflation in 2022. And the recent supply chain issues and energy supply problems in Europe and the UK only worsen things.

Additionally, UK government debt has enjoyed very low-interest rates compared to the growth rate. Previous work of mine has shown that government debt has a bubble term in this kind of economy, which efficiently contributes to multiple price levels or inflation paths, as inflation is a source of tax revenues.

How do we control inflation?

A standard prescription to stop the ‘pay spiral’ caused by excess demand is dramatically increasing interest rates and reducing government spending (e.g., austerity programs) to reduce private and public demand. For example, the famous Taylor principle suggests more than a 10% rise in interest rate to curb 10% inflation.

However, this approach may not be optimal or effective since the gap between aggregate demand and supply is led mainly by the persistent shortage in supply, not excess demand.

Dramatic tightening policies can also create recessions that lead to job losses. A better response, therefore, is restoring supply to a healthy level.

That is certainly not an easy thing to do. But it is worth trying. In the context of our times, it may need both workers and business owners to try to work together.

Investment and productivity

Neither a rise in wages nor a rise in profits can be sustained unless general productivity increases. Policymakers should not solely fixate on the exact percentages of wage increases and whether we see an increase or a decrease in profits. The crux of the matter is that investment in infrastructure and technology will be necessary to raise long-term productivity. A careful balance between raising salaries, taxing profits, and encouraging investment in infrastructure is the key. Workers need reasonable wages to provide quality services. The government needs another source of income to reduce tax revenues from inflation. Businesses are happy to cooperate only if productivity can contribute to the sustained growth of profits.

It is only through investing in productivity that inflation may be brought down consistently. When we have higher efficiency in providing goods and services alongside more easily anchored inflation expectations, we will be less likely to generate any pay spiral. 

I started the column with rail strikes, so let me end by considering the British train system.

Its latest infrastructure success story is Cross Rail, which connects the Great Western Main Line and Great Eastern Main Line and significantly impacts productivity.

Crossrail was first announced in 2009, and it is only in 2022 that London will begin to bear the fruit of such an investment. Even now, the rest of the country remains underserved by transport infrastructure, with many lines requiring refurbishment and the price of rail tickets undermining opportunities for low-income households to become commuters that can benefit from well-paid work.

Crossrail shows that policymakers must consider the long-term benefits of high-quality infrastructure investment and account for regional inequalities.

In reality, Britain needs greater productivity and a more significant regional sharing of the proceeds. It may not happen overnight, but today's challenges must be seen as long-term issues, and it will only take long-term thinking to overcome them.

Dr Wei Cui is Associate Professor Dept of Economics