Mervyn King says pay squeeze necessary

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Media captionMervyn King: "Higher import and energy prices and taxes have squeezed real take-home pay by around 12%"

Mervyn King has said that the squeeze on UK take-home pay is necessary.

Speaking in Newcastle, the Bank of England governor said the current high inflation rate was unavoidable as the UK economy adjusts to higher commodity prices and becomes more competitive.

He said inflation was likely to rise further to 4-5% in the coming months, before falling back sharply from 2012.

And he implied that the Bank would thwart attempts by wage-setters to keep up with the above-target price rises.

"Further rises in world commodity and energy prices cannot be ruled out," he said in his speech.

"Attempts to resist their implications for real take-home pay by pushing up wages would require a response [from the Bank's monetary policy committee]."

Despite this warning, his speech - which came in the wake of a surprise 0.5% contraction in the UK economy in the last three months of 2010 - appeared to downplay the chances of the Bank raising interest rates any time soon.

Commodity prices

The speech will make bleak reading for UK households.

Mr King noted that they have been hit not only by rising prices and lagging wages, but also by high existing debt levels, high interest rates from banks, and often an inability to borrow at all.

He blamed the high inflation rate - which rose to 3.7% in December, well above the Bank's 2% target - on three factors:

  • higher import prices thanks to the weak pound, which is needed to make the UK economy more competitive
  • rising energy prices and other commodity prices, such as cotton, food and metals, driven by growing demand from the developing world
  • rises in VAT, as the government begins to stabilise its finances

He considered all of these factors necessary as part of the UK economy's rebalancing away from domestic spending towards more exports - a process he claimed was already well underway.

Hard times

In total, Mr King estimated that these factors were contributing the equivalent of three percentage points to the inflation rate each year for four years.

Ignoring these external and temporary factors, UK domestically-driven inflation was virtually zero during the same period.

Indeed, the Bank governor noted that UK wages were stagnant, and - coupled with high inflation - this had led to the longest decline in the real value of take-home pay in the UK since the 1920s.

Nonetheless, Mr King claimed that hard times for UK wage-earners were, one way or another, inevitable.

If the Bank had tried to counteract the rising prices by raising interest rates, he said it would simply have led to falling wages - and therefore the same loss in purchasing power - but at the expense of an even deeper recession.

"Monetary policy can affect the inflation rate at which these adjustments take place," he said.

"But it cannot alter the fact that, one way or another, the squeeze in living standards is the inevitable price to pay for the financial crisis and subsequent rebalancing of the world and UK economies."

Chill winds

Referring to the recent disappointing UK growth data, the Bank governor appeared to disagree with the government's analysis.

He said the data bore out his earlier prediction that the recovery would be "choppy".

"Even abstracting from the effects of snow, growth at home slowed in the second half of last year," he said.

The comments contrast with the line taken by the government that the weak output figures were due to the poor weather in November and December.

"These are obviously disappointing numbers, but the ONS has made it very clear that the fall in GDP was driven by the terrible weather in December," said the Chancellor, George Osborne.

Mr King added that spending in the UK will continue to face "headwinds", as the pay squeeze is set to continue, households and banks are still struggling with their debts, and government austerity is on the way.

As such, the economy would be dependent on a rebound in exports to drive the recovery.

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