Public sector pay is not the only aspect of fiscal policy that can stoke inflation

Having made halving inflation one of his five key pledges, Rishi Sunak has warned that increasing public sector pay will fuel permanently higher inflation – an argument that the Treasury has repeatedly made over the last year. Many, including us, have questioned this logic, given that the main tool for controlling inflation ought to be monetary policy set by the Bank of England while fiscal policy objectives focus on redistribution and providing the desired quality and scope of public services. But while using fiscal policy levers to target inflation risks undermining these other objectives, if the government is sticking to this approach, then it suggests there are other areas of fiscal policy – beyond public sector pay – that it could be exploring.

The government is not paying enough attention to recruitment and retention

The recent news that junior doctors and consultants in England are planning coordinated strikes  ^undefined Junior doctors and consultants to strike together in England - BBC News  this autumn is a reminder that the government’s hardline approach has not brought an end to every pay dispute. And yet the Treasury’s evidence to pay review bodies earlier this year underlined its position.

There were around 70 mentions of “inflation” in the Treasury’s evidence to pay review bodies from earlier this year, and only a small set of bullet points on recruitment and retention that underestimated the scale of the problem.  ^undefined Junior doctors and consultants to strike together in England - BBC News  The Treasury’s evidence said only that improvements during the pandemic are beginning to “gradually unwind”, which is a much more benign picture of the recruitment and retention landscape than that highlighted by the IfG’s 2023 Performance Tracker: “in adult social care, there were 50,000 staff leaving the workforce in 2021/22. In the NHS, almost 10% of its roles were vacant at the end of September 2022: the worst gap on record. In schools, teacher training numbers are at crisis levels."

The government's argument is not convincing. It should primarily use public sector pay as a tool to recruit and retain the workers that it requires to provide the desired quality of public services. It is not a macroeconomic stabilisation tool: not only are its effect on inflation likely to be marginal, but it is also difficult to predict and calibrate its magnitude and timing. But if you do buy the government’s reasoning, then further questions follow about where it is targeting its approach.

There are two ways in which public sector pay rises could fuel inflation

The Treasury worries that higher paid public sector workers could pump more money into the economy at a time when it is already overheating with too much money chasing too few goods and services, and so push up prices further to rebalance demand and supply. This will happen if that higher pay is funded by borrowing, but not if it is funded through cutting spending or raising taxes elsewhere.  ^undefined Junior doctors and consultants to strike together in England - BBC News  Since departmental budgets are fixed in advance, the default is for higher pay awards to be offset by cuts to other areas of departmental spending.  ^undefined Junior doctors and consultants to strike together in England - BBC News

Its second concern is that paying public sector workers more could lead to further pay rises in the private sector, as firms are pushed to compete for scarce workers. Those higher wages in the private sector could then feed into higher prices for goods and services as firms attempt to cover their costs. This will be more of a concern if public sector pay rises run ahead of average awards in the private sector and if pay awards are significantly above core inflation, risking an ever-rising spiral of higher pay and prices.

The first of these channels applies to all other fiscal policies as well – any spending increases or tax cuts will tend to stoke aggregate demand and thus put upward pressure on prices.

To pick a not entirely random example, the government spends around £125bn a year on the state pension (a bit over half the cost of public sector pay). Most of that is indexed to the highest of earnings growth, CPI inflation and 2.5% (the so-called ‘triple lock’). That meant that this year the state pension increased by 10.1% in April  ^undefined Junior doctors and consultants to strike together in England - BBC News  – well above public sector pay awards of around 4 to 5%. Sunak has already said that he will retain the triple lock next year, meaning a further rise of around 8% next April.  ^undefined Junior doctors and consultants to strike together in England - BBC News  The default is for this higher level of spending to be funded through borrowing.

But the prime minister and chancellor do not seem to be concerned about these wider impacts of fiscal policy on inflation.

Other fiscal policies will not affect private sector pay – but they also do not offer other benefits

They may be less concerned about other types of spending because those will not – unlike public sector pay rises – risk stoking higher private sector pay rises. But, while that is true, factors on the other side of the ledger might tilt the balance the other way.

While higher public sector pay could risk fuelling higher private sector pay, it would also offer the benefit of helping to recruit, retain and motivate good quality workers in the public sector. Most other types of spending do not offer that advantage, although they will achieve other government priorities. All the costs and benefits need to be weighed to decide what the best approach is to achieve the government’s range of objectives.

The government should be wary of trying to use fiscal policy at all to tackle inflation – doing so risks cutting across the Bank’s monetary policy actions, undermining other fiscal policy goals and fiscal policies are typically not agile enough for this task  But if the prime minister and chancellor are seriously concerned about the impact of fiscal policy on inflation then they should look at all aspects of it, not only the public sector pay bill. There are clearly political reasons not to want to touch questions like the pensions triple lock with a barge pole, and there are pragmatic reasons not to reassess every area of fiscal policy. But if the government is committed to this approach to controlling inflation, the prime minister should be casting his net more widely than public sector pay alone.