Don't count on unemployment to reduce inflation

If the Bank of England think that there is a gentle trade off between inflation and unemployment, they should take look at the last time the UK went into recession.

Back in 1989, the UK had a raging housing bubble. As house prices increased, people felt richer and went out to the shops and spent like millionaires. Inevitably, inflation surged, and for one or two months, it reached 10 percent.

The chart above illustrates what happened next. The housing market crashed. People woke up and found out that they weren't as rich as they previously thought and stopped shopping. The UK slipped into a recession. Unemployment increased from around 7 percent of the work force to over 10 percent.

As the chart suggests, it took almost 4 years to bring inflation under control. It took 7 years for unemployment to return to the level reached in 1989. High levels of unemployment were not that effective at reducing prices.

There is a simple reason for this; so long as workers are not in any immediate danger of being fired, they will try to maintain the relal value of their earnings. When recessions fire up, only the most marginally profitable firms go under. Even in deep down turns, most people are not in any real danger of losing their jobs. Therefore, they keep demanding inflation adjusted pay increases.

The MPC thinks it can negotiate with inflation. Once inflation gets going, it doesn't pay much attention to unemployment. There is only one tried and tested way to reduce inflationary pressure; reduce monetary growth.