The costs of entrenched high inflation cannot be ignored

“Somehow, in the UK, someone needs to accept that they’re worse off and stop trying to maintain their real spending power by bidding up prices [or] wages or passing the energy costs on to customers.” This comment by Huw Pill, the Bank of England’s chief economist, has set off a firestorm.

Is he right? Yes, but only up to a point. Is lecturing people useful? No. What is useful is for the BoE and other central banks to show that they will do whatever it takes to bring inflation back under control.

Pill’s point is that the UK has suffered an exceptionally large deterioration in “terms of trade” (the ratio of its export prices to those of its imports). Between December 2020 and September 2022, this fell by almost 10 per cent. Since prices of imports rose dramatically, this raised the overall price level, while making the country significantly poorer. Pill is right on this.

Yet it also creates a distributional struggle, the outcome of which will be determined by political and economic power. Such a struggle would also have happened if the UK were self-sufficient in the goods whose prices rose. Domestic producers of oil, gas and food would have gained at the expense of everybody else. The fact that the redistribution is to foreigners just made it costlier overall.

However, the loss of real income is not the only effect of the deterioration in the terms of trade. One must also consider the effects of the inflationary process itself. This is never smooth. Some groups are better at getting ahead of inflation than others: businesses, for example, can adjust prices faster than workers can force up wages. Public employees and people on benefits are likely to find gaining upward adjustments of their incomes especially difficult. Pill is right that this process will be futile, in aggregate. But it will not be at all futile for the winners if they succeed in protecting their incomes by shifting most, or even all, losses on to others.

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The fact that an inflationary process is arbitrary and unjust is one of the reasons it is so politically and socially corrosive. After the long period of low and stable inflation, many have forgotten this. But those who lived through the 1970s remember it well. Today’s labour unrest is reminiscent of what happened then. It was also quite predictable.

The impact of slow adjustment to inflation is particularly harsh on the recipients of benefits. The Resolution Foundation notes, for example, that the real level of unemployment benefit fell 12 per cent between March 2021 and March 2023. These are very large falls in the real incomes of already poor people. Moreover, with headline inflation at 10 per cent, real wages fell 3.2 per cent in the year to February 2023, despite a 6.9 per cent rise in money wages.

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Nevertheless, optimism is possible. One reason is that headline inflation is about to tumble, as the increase in prices after Russia’s invasion of Ukraine falls out of the index. This will deliver a sharp fall in headline inflation, so improving real wages and disposable incomes, and weakening wage pressure.

Another reason for optimism is the fact that market expectations of average inflation are 3.5 per cent over the next decade. This is not far from the BoE’s target, once we take an inflation risk premium (plus the fact that index-linked gilts use the retail price index, rather than the consumer price, as the measure of inflation) into account.

Yet I am unconvinced. Real wages in February were nearly 5 per cent below their level in March 2022. After such large losses in real wages and disposable incomes, why would one expect growth in nominal wages (which was 6.9 per cent in the year to February) to slow sharply, especially when core inflation was 6.2 per cent in the year to March 2023 and unemployment was as low as 3.7 per cent in the fourth quarter of 2022? What is likely to bring about a really sharp fall in wage growth?

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Standard economic models also assume that the inflation target is self-validating: if people generally believe it will happen, then it will. Yet expectations will always adjust to experience. If, as I expect, wage growth continues at not far short of today’s pace, productivity growth stays low, and so unit labour costs continue to rise quite fast, the core rate of inflation seems likely to stabilise well above target. Moreover, monetary policy is not even tight by normal standards: the Bank of England’s intervention rate of 4.25 per cent is well below core inflation, never mind the headline rate of over 10 per cent.

Yes, the BoE cannot fix the income distribution. That is for the government to do. What it can and must do is stop inflation from remaining too high for too long. The costs of dealing with entrenched high inflation would be huge. It is the BoE’s job to prevent this.

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