Wages or Profits? The dynamics of Supply-Side inflation the Bank of England forgot to mention

Recently, Bank of England economist Huw Pill put his foot in his mouth by stating that people should just accept they are poorer and stop asking for pay rises.

Or at least that's what the papers will have us think.

What did Huw Pill really say?

The full context of his statement was:

"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, whether through higher wages or passing energy costs on to customers etc

"What we're facing now is that reluctance to accept that, yes, we're all worse off and we all have to take our share; to try and pass that cost onto one of our compatriots and saying: 'We'll be alright, but they will have to take our share too'.

"That pass-the-parcel game that's going on here, that game is one that's generating inflation, and that part of inflation can persist."

The thing is, Pill's statements are completely factually correct. The price of goods in the shops, as they are sold to me and you, is an amalgamation of the cost of wages with cost of the stock, whether that is food, goods or something else.

The Mathematical Dynamics of Price Rises

The nature of macroeconomic concepts like GDP, GVA or GNP or microeconomic concepts like pricing, both have a dependency on the salaries of the people. In the case of GDP, the standard yield equation has 4 key dependent variables. Two of which, consumption and government investment, are indirectly dependent on residents. Both to earn enough to pay taxes either as PAYE/NIC on earnings and VAT on consumption. Businesses also pay corporation tax, which itself, trades off against wages. The only way to pay more in corporation tax is get higher profits, but that can only happen by greater sales and/or lower costs, including wages.

As has become painfully clear over the last 2 years, the component of the cost of living crisis caused by wholesale energy prices, is legally sanctioned profiteering. As Ofgem, which has the capability to unpeg renewables from the price of gas, chose to create bailout conditions without the intermediate government to do it. Passing on the costs directly to consumers and business, who in turn passed the on to consumers by proxy.

Yet, this is only one of two key phases in the economic trajectory of inflation.

In all economic systems, there is a perturbation phase, under which things are relatively linear, or can be approximated by it, and there is a non-linear, let's call it perturbed, phase. Where a feedback system exists which requires consumers to both require pay rises to close the costs gap and cover the costs of that pay rise themselves. One way or another.

This usually cannot be controlled by linear thinking and rapid cycling that feedback loop triggers hyperinflation and a descent into chaos.

The linear phase in this case, is driven by supply side inflation costs. It is this period of the cost of living crisis that occurred when energy started spiking but before the first pay rises were paid.

In any business, wages are the biggest component of a product's cost. Supply side inflation makes up only some 30% of the price you pay for that good.

The rest is overheads for the store, which can include energy and transportation, as well as a wage bill which is upwards of 60% of the cost of the good you pay.

But the only part of the component of the price of a good, that is nonlinear, is the wage component. What you always need to do is catch inflation before it enters that nonlinear phase, otherwise runaway inflation is a serious threat.?

While the Bank of England didn't do that, it also had limited instruments at its disposal to deal with imported inflation from energy in any event. Government and Ofgem failed to act to help them out and so we find ourselves where we are.

Worked example:

1. A loaf of bread is ￡1 in 2020 to consumers?

2?The cost of the loaf to the store was 20p in bulk

3. The cost of transportation is 5p

4. Cost of wages 60p

5. Overheads, inc energy is 10p

6. Margin is 5p

Lets suppose the cost of overheads triples because of the cost of living crisis, energy and transport costs double and the original cost of the Good As It imported, doubles too. These are all supply side or "imported" inflation. There is nothing the Bank of England can do about this, but it means that loaf now costs.

1?The cost of the loaf to the store was 40p in bulk

2. The cost of transportation is 10p

3. Cost of wages 60p

4. Overheads, inc energy is 20p

So the loaf is now ￡1.30 and the business has lost its margin completely (the reason why we calculate at margin=0, is because this is the point at which they have to make people redundant)?

As an aside, there was nothing the Bank of England can do to tackle imported inflation, because as soon as it tries to raise interest rates you raise the cost of everything else there is nothing it can do about stuff that the UK imports including inflation.

Now, because Jo Public can't afford to buy that loaf anymore, they have to get a pay rise of 30% to maintain the same standard as before. They don't get 30% but they might get 20%. But what does this do to the price of a loaf?

1?The cost of the loaf to the store was 40p in bulk

2. The cost of transportation is 10p

3. Cost of wages 72p

4. Overheads, inc energy is 20p

5. Margin is 0p

It makes the price ￡1.42. So instead of being better off, the worker is not only poorer by 10% in terms of their buying power against the loaf, they are actually down 21% in total from the original price and that is because prices rose due to their wage increases.

So because they are poorer, they now have to ask for another wage rise of 6 percentage points (which for the loaf, has to come from the costs that aren't the wages of the employee). But there's no margin. So the price has to go up again and the loaf now becomes:

1.?The cost of the loaf to the store was 40p in bulk

2. The cost of transportation is 10p

3. Cost of wages 78p

4. Overheads, inc energy is 20p

Leaving the loaf at ￡1.48

Which still leaves the employee paying 48% more for the loaf than they did 2 years ago and this was without any margin whatsoever! Energy providers are only one part of a complex supply chain. They are also the one that all other business are hit by. However, the intermediate businesses between energy and retailer can only absorb so much. Notwithstanding that, even if they couldn't you can see how much it increases (48%) with only salary increases.

The Moral of the Story

The 3 key takeaways with this are:

1. You can never catch runaway inflation, by increasing wages because wages for workers are priced into the cost of the good that workers pay for?

2. The only thing the BoE could have done, was 15 months ago, act. But they didn't. Now it's got to the stage of being self sustaining, there is nothing they can do to stop it.

3. Workers cannot stop asking for greater pay rises in an economy which has differential approaches to it, because they risk being left behind while other economic sectors in the same economy do give pay increases, as those prices increase inflation anyway. The only place that can be done is in the service sector as the contribution to consumption costs is relatively small.?

The flipping point from when it was goods and energy, to wages, is when the first set of pay rises was paid. This turns it from that initial perturbation, into a brand new non-linear perturbation and the proverbial financial energy of the extra cost of living, took it from supply side inflation to being driven mostly by wages and wage increases, on a permanent basis.?

There is only one component of the costs that make up the cost price of a good that is self-referential and that is the cost of wages.

Epilogue

Now, for completeness, it's worth talking about inflation caused by gentrification processes. Because in general, that does not cause a cross sectoral increase in prices. It only facilitates an increase in luxury items. Not so much essentials. So it doesn't broadly affect the wider economy in a short period of time. That's what makes this inflation fundamentally different from a population dynamics perspective, on top of the supply-side cost of living impacts.?