Column: Nigel Sillis

Labour costs are rising even though labour is no more scarce. How is this happening?

The young lady who does my ironing - for the avoidance of doubt, this is not my wife - has posted a note through my door. If I wish to continue availing myself of her 'collection and drop-off' service then, unfortunately, her weekly fee must rise by around 10%. It's fuel prices, you see!

A simple anecdote, but it contains two key issues:

- The transmission mechanism between headline and core inflation.

- The nature of fixed versus variable costs.

Firstly inflation. The consensus is that rising headline inflation has been caused solely by energy and food prices. As global activity slows down, demand for energy reduces and the price falls. The pressure on food prices abates as harvesting cycles normalise and the diversion of productive capacity towards bio-fuels reduces (the folly of substituting hydrocarbon for carbohydrate production is a whole new chapter by the way) helped, of course, by lower input costs for the fertiliser industry. Headline inflation moderates and converges to more comfortable core levels.

What if this consensus is wrong? Inflation is the rate of change in the value of goods and services measured in terms of money. In periods when goods and services are relatively scarce and money is not, the value of money declines and positive inflation results. If even more relative scarcity affects a few products - say energy - then the value of it increases in terms of non-energy products and money, and headline inflation becomes more positive than core inflation. All of this so far has been measured in terms of 'money' not 'labour'. Over short periods of time, however, 'money' and 'labour' are closely aligned - to a greater or lesser extent individuals provide labour for fixed value in terms of money. They can, of course, ask for more and thus devalue 'money' in terms of 'labour' but they can only be successful is labour is scarce relative to money. Is it?

Back to my ironing-lady. Is her labour scarce? Did her request for a rise succeed? The answers to these questions, contrary to theory, are no and yes. I'm sure that I could replace her labour at a lower premium but there is a frictional cost associated with this strategy. Would the putative new provider offer as reliable and convenient a service? Additionally, I value my time - should I spend some of it pursuing a trivial saving in my expenditure? So I paid up and allowed my personal inflation rate to rise. My ironing-lady correctly estimated that the scarcity of her 'service' (a more holistic concept than just her 'labour') was enough for me to devalue my money.

The same story is currently playing out on a grand scale throughout the German economy. After years of underperformance whilst post-unification stresses evened out, unit labour costs are now rising as labour becomes relatively scarce. Scarce not in terms of quantity but scarce in terms of availability given all the inherent frictional costs of change. This worries the ECB and policy making is directed accordingly: there is more core inflationary pressure than is currently appreciated.

It's a fix

And now onto fixed versus variable costs. Analysts like this neat concept. It allows them to forecast the marginal effect upon profitability of revenue changes. But no fixed costs are truly fixed (usually they 'step' according to desired production capacity) and no variable costs are truly variable (usually they have de minimis levels - same fuel to collect five shirts as six!).

The leading indicators of change in profitability are derived by analysing an enterprise's business condition not by slavishly number-crunching financials. Analysts should consider the relative scarcity of inputs - capital, commodities, labour and property - versus that of outputs. One thing that is scarce just now is capital and that augurs well for hoarders of it. Those high-yield, leveraged industrials with modest product differentiation and little capital fare poorly in my expectations.

Nigel Sillis is director of fixed-income and currency research at Baring Asset Management in London.