Low inflation? Think again...

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BT Group, the telecoms giant, is facing wage demands from its employees' union that could add more than £300m to its payroll costs, says Andrew Murray-Watson in The Sunday Telegraph. "The Communications Workers Union (CWU) is demanding that BT, which has over 100,000 staff, grant its workers an inflation-busting 8% pay rise." Reports from BBC Radio 4 suggested the offer from management is only around 2%. About 70,000 of BT's staff, according to Murray-Watson, out of 86,000 in the UK, are CWU members. In a statement, the CWU said the claim was "realistic". Why? Because, says the union, BT can afford it. BT's profits were £1.09bn for the last interim period and the union argues that the firm's board and shareholders have already enjoyed significant payouts over the past year. The union feels it's time the workforce shared in the profit recovery.

This is absolutely textbook late-cycle inflationary pressure and exactly the sort of thing that Mervyn King, governor of the Bank of England, has identified as one of the biggest threats to the Bank's ability to keep to its inflation target. Wage cost-push inflation occurs when workers demand higher wages, which push up companies' costs, eventually forcing them to hike their prices. Higher prices raise the cost of living and cause the unions to demand higher wage settlements again and again. A classic inflationary spiral ensues.

Profit squeeze

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Input prices have been rising for UK companies for some time, thanks to fast-rising commodity prices: input prices (raw materials and wages) were up 11.4% in both February and March. But so far, firms have not felt able to raise prices and so have largely had to absorb those costs themselves: output prices are only 2.8% higher than they were last year. The inevitable result of this is that margins have been squeezed and, as Gary Duncan points out in The Times, "profit warnings by British companies have leapt by a fifth and business confidence has tumbled". While firms can optimistically imaginethat sharply higher energy costs could still prove to be temporary and their profits should therefore rebound, there is absolutely nothing short term about the costs of higher-than-inflation wage settlements. These costs are long term and fixed, so eventually managements have no choice but to try and pass the pain on to consumers in the form of higher prices. As such, you can be sure that the Bank of England's Monetary Policy Committee (MPC), already concerned over the double-digit input-price increases, will be watching the output-price data like the inflation hawks they are soon to become.

So just how painful might this get? Andrew Taylor, writing in the FT, reports that, according to the pay and benefit specialists Incomes Data Services (IDS), the median level of pay settlements in the first three months of this year was 3.3%, compared to 3% in the corresponding period last year. The much wider, but somewhat delayed, survey by the Office of National Statistics (ONS) reports that "in the year to January 2005, wage growth was 4.4% with 4.6% for the public sector." Both sets of numbers are way ahead of consumer price index (CPI) inflation, officially growing at just 1.6%.

Leading the way in public-sector wage demands are the bureaucrats, administrators and managers. The Daily Mail's Jenny Hope, for example, reports that Incomes Data Services (IDS) looked at pay rates for 2,500 NHS chief executives and directors in the year to last March (presumably it's got even worse since then). "Across the country, average pay awards for chief executives were around 7.5%," Hope reports. However, although Gordon Brown's cavalier largesse with the public purse is boosting many public servants' pay packets, some still feel they haven't had their fair share at the punch-bowl. Paul Noon, general secretary of civil service union Prospect, said: "Many long-serving staff are being forced to accept increases below the rate of inflation at a time when earnings across the economy are rising by 4.5%." That doesn't make them happy at all.

A free-for-all in pay deals

Civil service unions have launched a campaign to restore national pay bargaining to remove "huge pay inequalities and inefficiencies caused by more than 200 different sets of pay negotiations". The Public and Commercial Services Union and Prospect, representing 80% of civil servants employed by central government and agencies, called for a return to a single national pay deal to reduce the "damaging impact of current government pay policy towards its own employees". Roughly translated, this means the unions want to do away with locally negotiated wage differentials, such as the London weighting many now get. No prizes for guessing that this will involve upwards-only pay reviews for the laggards. As if to confirm this, the unions are seeking a basic minimum annual starting salary of £13,500. A quarter of civil servants now earn less than £13,750, say PCS.

Meanwhile, in a disturbing precedent (at least from the point of view of wage inflation) Unison, Britain's biggest public-sector union, has won what David Turner describes in the FT as, "the biggest equal-pay award in British history: 1,500 of its women members stand to gain back-pay of between £35,000 and £200,000 each from North Cumbria Acute NHS Trust."

What all this suggests is that we could be on the verge of a national pay-rise free-for-all, as public-sector managers try to chase their private-sector peers, front-line services chase their bosses' gains, all levels look to close differentials and women seek to close the gap with men.

Higher pay means inflation

The trouble with wage demands is that once one group gets a big award, suddenly everyone feels entitled to something at least as big - to maintain "differentials", as the old union mantra used to go. The feel-good factor of rising house prices is on the wane and workers are suddenly looking to their wage packets to make up the difference. With corporate profits as a share of GDP historically high, and low unemployment creating skill shortages, the private sector is hardly in a position to put up much resistance. However, the pressure on private-sector bosses is as nothing compared to the public-sector steamroller once it gets going. Public-sector unions have historically seen large new funding commitments from the Treasury as legitimate plunder for sorting out longer-term low-pay frustrations. Pension provision concerns, as well as the way managerial-level employees are perceived to have been feathering their nests, will only have inspired them.

Public-sector wage growth is already running at three times the rate of inflation - and rising. By the end of this year, it could be totally out of control. No wonder, says Taylor, "many economists believe that rates will need to rise by at least a further quarter percentage point later this year to ease inflationary pressures caused by rising wages and higher import prices". The only question is, will a quarter point be enough?

James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.