After wages grew faster than expected in the three months to November, is the UK economy overheating?

Mark Carney
The Bank of England's next move is likely to be to tighten policy (Source: Getty)

Charles Dumas, chairman and chief economist at Lombard Street Research, says Yes.

The 2016 British economy was at or above its potential, with no slack. Official estimates of a little slack ignore domestically generated inflation picking up fast.

If you impose a 15 per cent devaluation on an economy already fully employed, you do not just get inflation to reflect the higher cost of imports – you get wage inflation to compensate workers for their loss of purchasing power. Did anyone mention strikes?

Imports are about one fifth of total supply: devaluation of 12 to 15 per cent raises total costs by 2.5 to 3 per cent, unless foreign exporters to the UK shave their profits. If wage bargains shift at all in response to this, the inflation of costs will be substantially greater.

But why should businesses accept shrinking margins? Consumer spending is strong, and devaluation helps exports and improves profitability. Capital spending is more likely to rise than fall, now that the Brexit scare stories are ebbing. The economy is overheating, and the Bank of England’s next move will be to tighten monetary policy.

Paul Hollingsworth, a UK economist at Capital Economics, says No.

No. Admittedly, inflation looks set to rise above the Bank of England’s 2 per cent target in just a few months’ time, and will reach about 3 per cent by the end of the year. But this is largely a result of external factors rather than a significant pick-up in domestic cost pressures, in particular rising import costs as a result of the post-referendum drop in the pound.

Higher inflation will squeeze growth in households’ real incomes, and will take some of the wind out of consumers’ sails this year. Although wage growth is starting to pick up too, it is worth noting that it remains below the 4 per cent plus rates that were typical in the pre-crisis period. What’s more, there have been some more encouraging signs on the productivity front recently.

Higher productivity means that the economy can continue to expand robustly without cost pressures getting out of control. Accordingly, it looks premature to worry about the economy overheating.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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