Inflation, unemployment and UK 'misery'

Job centre sign Image copyright PA
Image caption Which causes more misery, unemployment or inflation?

We've just had two big UK data releases - inflation and unemployment - which showed no dramatic improvement, but at least things aren't getting worse.

However, the continued squeeze in wages is a reminder of how far the UK still has to go before the recovery feels more like one. It's prompted me to take a look at how Britons have fared through what's called the "misery index".

Back in the 1960s, the economist Arthur Okun came up with a simple way of summarising the change in national welfare. The misery index is just the sum of two economic "bads". They are: inflation and unemployment.

This week, we learned that consumer prices in September were 2.7% higher than a year earlier. Although this is above the 2% inflation target of the Bank of England's Monetary Policy Committee (MPC), it is below the 3% rate that would trigger an open letter of explanation from the Bank of England governor to the chancellor.

Since taking office in July, Mark Carney has not yet had to write any letters. Looking at the central projection for the consumer prices index (CPI) inflation rate in the last Inflation Report, the MPC does not expect inflation to rise above 3% in the next three years - although there are comfy margins of error around this assessment.

His predecessor, Mervyn King, had to be more active with his pen. There was only one month between January 2010 and March 2012 when inflation was not above 3%.

Now we have learned that the unemployment rate in the three months to August remained at 7.7%. Before the financial crisis, the unemployment rate was hovering at just over 5%. Because of the weak economic recovery, unemployment has been stubbornly high in comparison.

However, the rise in unemployment has been modest compared to previous downturns. In both the early 1980s and 1990s, unemployment breached three million people, well over 10% of the labour force.

Furthermore, the Bank of England has pledged forward guidance that interest rates will not be raised until unemployment has fallen below 7%, bar any unpleasant news on inflationary pressures.

Earnings squeezed

So adding the unemployment rate to the consumer price inflation rate gives an overall misery index of 10.4. This is much higher than in the decade leading up to the financial crisis, a period known as the Great Moderation, when the UK misery index averaged below seven.

But it is not so high when you look historically. After the quadrupling of oil prices in 1973, subsequent high inflation saw the misery index approach 30 in 1975.

The stagflation of the late 1970s meant that the misery index was about 25 in 1980. During the early 1990s recession, the misery index also spiked at over 16 in 1991.

So with the recent inflationary pressures appearing to ease and the MPC putting more weight on unemployment in the setting of monetary policy, you would expect the British to be less miserable going forward.

However, recent increases in food, energy and fuel prices at a time when wage growth has been anaemic have reduced real earnings. The squeeze on living standards is likely to be a key battlefield going into the next general election.

Just a reminder: inflation measures the rate of change in consumer prices, not the level of prices. This means that past increases in prices will eventually drop out of the inflation calculation, but you will still feel them in the price you pay for goods and services.

Over the last four years, the index of consumer prices has risen by nearly 14%. Had it gone up in line with the inflation target, it would have been a little over 8% higher.

According to the ONS, food (up 19%), gas (up 21%), electricity (up 25%) and road fuels (up 29%) have accounted for the majority of the increase.

Perception problem

However, not all prices have risen so quickly. For example, the prices of clothing (up 5%) and household appliances (up 6%) have increased at rates below the inflation target.

And some prices have even fallen over the last four years. Motor vehicles are 0.5% cheaper, largely due to a significant fall in the price of second-hand cars.

Audio-visual equipment and computers are 25% cheaper, although for many of these goods, it's because the ONS makes an adjustment to the price to reflect rapid improvements in quality.

Note that the prices of things we buy regularly and class as necessities have increased the fastest, while those we buy less frequently and could delay the purchase of have shown more restraint.

This, perhaps, gives the perception that inflation is higher than the official rate suggests. We would be more aware and sensitive to where prices have been increasing quickly than where they have been increasing more slowly or even falling.

The situation for British households is made worse by the slump in earnings growth. Over the last four years, regular pay has increased at about half the rate of inflation, meaning real (adjusted for inflation) earnings have been falling an average 1.6% per year.

In the past, it has been argued that the misery index should place a higher weight on unemployment than inflation. This is because workers were typically compensated for increases in the cost of living with higher wages.

Studies to measure happiness, quite the in thing these days, also stress the detrimental effects of unemployment on individual and societal well-being. But at present, it might be inflation that is the bigger cause of British misery.