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All the conflicting pressures that the Bank of England's Monetary Policy Committee (MPC) felt at its July meeting, which resulted in a three-way split in the voting, were intensified this month. Economic activity weakened still further while inflationary pressures increased. Consequently, inflation was too high for a cut in the Bank rate, to support output and employment, while GDP growth was too fragile for the rate rise some felt was needed to curb price rises. Faced with being pulled in opposing directions, the MPC did the sensible thing: nothing.

While the MPC undoubtedly accepts the need for lower interest rates to stimulate the economy, it seems less convinced by the arguments that higher rates are required to dampen the current surge in inflation.

This might seem surprising given that the Consumer Price Index (CPI) is currently running at 3.8%, which is by far the fastest rate since the Bank was put in charge of monetary policy in 1997, and likely gas and electricity price increases may well push it up to 5%.

It is generally accepted that changes in interest rates take 12-18 months to work their way through the economy. If, therefore, the recent jump in prices is just a short-term spike, raising rates now is unnecessary. It will do more to damage confidence and spending than it will to control inflation. And the MPC, charged with achieving a medium-term target for inflation of 2%, believes that price pressures will ease in the coming months. Retrenchment by households will help, as will a continuation of the recent slide in the oil price to under $120 a barrel.

Changing workforce
Once this process is underway, the interest rate question is then about the timing of the next reduction. By a very significant majority, economists and forecasters are expecting rates to fall next year, perhaps by as much as 25 basis points a quarter, leaving rates at 4% by the end of 2009. Given the leads and lags in the system, however, this will not necessarily stimulate an immediate rebound in activity, so the environment in 2009 will be just as difficult as this year.

Central to the MPC’s view of inflation is the assumption that the benign trend in earnings growth continues. The labour market has long been the entry point for inflation into the UK economy. However, in the past few years, this trend seems to have reversed. Employment has grown to record highs, unemployment has fallen to 35-year lows, yet earnings growth has been subdued. This has led to speculation that there has been a significant structural shift in the behaviour of the labour force, avoiding the inflationary wage spiral.

In the first place, a sizeable chunk of our economy, namely manufacturing, has been exported in the past 30 years to low-cost economies. Manufacturing used to be the most unionised part of the UK economy, the base for the big union battalions of the 1970s. Trade union membership, which in 1979 was 13.2 million, is today around 7.5 million. Secondly, union activities have been constrained by the changes to the legislative framework for industrial relations implemented in the 1980s. Finally, the influx of migrant labour has prevented a shortage of workers developing, so helping to keep a cap on pay settlements.

The concerns of policymakers about pay are, nevertheless, understandable. As a country we cannot pay more to overseas suppliers for oil and food while at the same time maintaining our standard of living by bargaining for higher pay, as we did in the 1970s with dire inflationary consequences. Although there seems less to worry about today, the risk is the public sector, where trade union membership is still strong. Having been boosted by Mr Brown since 2001, its expectations have been raised. And the fear is not just about pay but that public sector settlements becomes the benchmark for the rest of the economy.

Like it or not, we have to accept that if more of our income is going elsewhere, some reduction in living standards is on the cards. Just how the pain is distributed is up to the government, but if we think we can get around it with higher pay, Mr King and his colleagues will get us with higher interest rates. At an aggregate level, it is a no-win situation.