Is Rishi Sunak picking the right targets in his anti-inflation battle? | Public sector pay

Fresh from urging mortgage borrowers to “hold their nerve” in the face of dramatic increases in repayments, Rishi Sunak now appears to be preparing to squeeze public sector workers in his battle against inflation.

Asked this week whether he would implement the recommendations of independent pay review bodies for staff including teaching and doctors – which are believed to be calling for increases of between 6% and 6.5% – he said staff “need to recognise the economic context we are in”.

Throughout the lengthy industrial disputes with teachers, NHS workers and other public sector employees, ministers have repeatedly warned that meeting their demands could exacerbate the UK’s inflation problem.

But many economists question whether bearing down on public sector pay is really the solution.

There are two ways in which generous public sector pay rises could in theory boost inflation: by setting off or exacerbating a “wage-price spiral” and by boosting demand in the economy.

The much-dreaded “wage-price spiral” is strongly associated with the 1970s experience in the UK. It sees workers responding to an inflation shock (rocketing oil prices, for example) by bidding up their wages. Companies then respond by pushing up the prices of goods and services to accommodate these higher labour costs, and the cycle goes on.

Fast-forward to 2023, however, and public sector workers can hardly be accused of driving up economy-wide wage levels: for much of the past two years, public sector pay has lagged well behind increases in the private sector.

In the three months to June 2022, for example, public sector pay was growing at an annual rate of 1.7%, compared with 5.9% in the private sector.

There has been some catchup, with the most recent data, covering February to April this year, showing a 5.6% increase across the public sector against 6.7% for the private sector. But it is hard to argue the public sector is leading the way.

Pay in the sector has remained below inflation for much of the period since the pandemic – and indeed for much of the period since the Liberal-Conservative coalition came to power in 2010.

Some economists are sceptical that wages are the key to the UK’s current inflationary malaise. According to David Blanchflower, a dovish former member of the Bank of England’s monetary policy committee, this is nothing to do with demand. “It bears no relation to what happened in the 1970s. What you’ve got here is three shocks, and they’re all supply-side shocks – you’ve had Covid, you’ve had the Ukraine war and you’ve had Brexit.”

James Meadway, of the Progressive Economy Forum, agrees. “The assumption that inflation’s being driven by demand, I don’t really think holds up,” he says. Instead, it is “these big shocks of the past few years, which are now washing out, which is why inflation is now likely to come down anyway”.

However, many other economists insist restraining demand will have to be part of the solution to the current crisis – which is ultimately what the MPC is trying to do, by raising borrowing costs.

And this is where the government’s second argument comes in: a chunky pay increase for public sector workers, funded by public borrowing, would be counterproductive, because it boosts demand in the economy – and hence, potentially, inflation – at a time when the Bank is trying to do the opposite.

“What’s right about this argument is that other things being equal, borrowing-financed deficit spending is likely to add to inflationary pressure,” says Prof Jonathan Portes, of Kings College London.

However, he rejects the argument for two reasons – first, any increase could instead be financed by raising taxes, perhaps on the highest-paid, whose incomes have been rising fastest. “You don’t have to finance it by borrowing.”

The sums involved are relatively modest when taken against public spending as a whole. The IFS calculated last year that giving public sector workers across the board a 10% pay increase would cost an additional £18bn, over and above the 3% the Treasury originally allowed for.

But ministers have since settled at 5% – plus a one-off payment – with hundreds of thousands of NHS workers (though nurses remain in dispute); while the pay review bodies for teachers and doctors are expected to suggest a more modest 6-6.5%.

The second argument against the claim that a pay rise would be inflationary by boosting demand is that any immediate benefit is likely to be more than outweighed by the longer-term costs of the exodus of staff from creaking, overstretched public services, who are, as Portes puts it, “voting with their feet”.

“One way or another, we are going to end up paying more for teachers and doctors, because the market is going to determine that. We know that,” he says. “And so all the government does by holding this down is damage public services, damage morale, damage relationships with their staff – and it’s all for nothing.”