Alternative Ending

31/03/2017 at 3:55 pm

Counterfactual writing has been popular for many years. What if the Nazis had won the war in Europe? What if there had been no Reformation? Extending the genre to finance one might ask, what if the bond market had closed to Italy in 2011? (More of a niche market there, perhaps, but an interesting question nonetheless . . . )

Investment decision making by contrast concerns the future, of course, whose range of outcomes is practically limitless. Where the FTSE 100 index will close the year is a matter of opinion. A successful investor could be defined as someone who gets those sorts of things right more often than she gets them wrong. The only certainty she has, however, is that the future could hold almost anything.

And so to inflation, the UK, and what happens next.

The data out last week showing another uptick in the rate of price increases in Britain will have come as no surprise to readers of this blog. CPI is catching up with PPI output prices which have continued to catch up with PPI input prices, which have continued to come in at around 20% higher than the same time twelve months previously. Notably, “RPIX” – the rate of retail price inflation excluding the impact of mortgage interest payments and the rate once targeted by the Bank of England – came in at +3.5% year-on-year (to February). A full point above the old target, that would once have provoked a letter from the Governor to the Chancellor. CPI has only just got up to +2.3%, however, so under the new regime there is officially nothing to worry about.


Bearing in mind the enormous range of possibilities encompassed by the future we ought to be surprised at the strength of the consensus about what happens next. The Bank, the City, the leading independent forecasters: all are agreed that rising inflation will eat into wage packets, dampen growth, soften the labour market a little then fall away again. This time we all know how the story will end.

Taking this as read, then, let us try to be counterfactual, if only for entertainment’s sake.

On February data, real wage growth either flatlined (using CPI) or fell by 1% (using headline RPI). Let us follow the consensus in assuming that inflation grows by another point or so into the end of this year. That would push real wage growth down to between -1% and -2%.

Now: what if the effect of this was not only, or primarily, to impact growth? What if the expectation that wage growth will muddle along at a steady +2% is wrong? What if earnings actually start to rise to compensate for higher prices?

Like any good counterfactual tale our story needs to have its roots in genuine history to come across as believable to its readers.

In this case we might look at the distance travelled by the UK economy since the unemployment rate peaked in November 2011 at 8.5%. At that time average earnings growth was coming in at +1.7-1.8%, just a little lower than its present rate, though at the time this was a noteworthy trough and a level not seen since 1967. Wage growth subsequently fell further, hitting lows of +0.7-0.8% during the 2013-14 period. During those two years, however, employment growth had taken off in earnest with joblessness falling from 7.8% to 5.7%. Average earnings growth subsequently rose too, hitting +2.8% by mid-2015.

That British pay packets began to grow as spare workers became that bit harder to get hold of might well have been a complete coincidence. Indeed if we are to believe that earnings growth will not continue to accelerate today, as unemployment is down even further at 4.7%, equalling its post-1975 low, then that must be taken as read. The consensus, after all, is convinced of it.

Let us persist with our radical, counterfactual account, however. Suppose that labour market strength might genuinely correlate with wage growth. Where might that take us?

Prior to the Great Recession the average rate of earnings growth in the UK was +4%. Using a five-year lag from earlier peaks in unemployment wage growth reached +4.9% (February 1998) and +9.3% (May 1989). The economic, market and demographic environments were very different in their own ways at each of those different times, so the absolute numbers are not perhaps that illustrative. What they have in common is that they occurred during uptrends in wage growth established in the wake of falling unemployment.

For our fictional account of the British economy, then, let us assume that 2017 were to end with average earnings growing at 3-4%. With CPI and RPI inflation settling in the same range this would not represent boom times for wage packets in real terms. But it would not mean a growth-threatening contraction either. Expectations for increased labour market slack would surely go out of the window. Inflation projections would rise. Interest rate expectations would change. We might be entering 2018 worried not so much about contraction as about an overheating economy and a monetary policy that looked to have long since fallen behind the curve.

This is hardly a gripping, mass-market narrative. But it is the kind of thing that investors might want to weigh up in their thinking from time to time.

At least it would be if it were not the most absurd counterfactual, of course. Luckily the consensus is universally settled. We all know what is going to happen. In Britain’s immediate future, there is no alternative ending.


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