Bond Outlook January 3rd

January 02, 2007

Central Banks loath wage inflation. Whether governments want to see greater household spending or not, Central Banks will always apply brakes. Do not therefore expect a decline in interest rates.

Bond Outlook [by bridport & cie, January 3^rd 2007]

The last months of 2006 saw the beginning of a reversal of a powerful movement evident in most Western economies since 2000, viz., that of higher corporate profits while wages and salaries hardly kept up with the cost of living. This phenomenon of “squeezeflation” is easily explained: competition in manufacture and tradable services from Asia weakened labour’s bargaining power, while companies were able to reduce costs through sub-contracting and “forced” productivity gains. Thus, even though the same Asian competition put a ceiling on selling prices, corporate profits continued to increase.

Slightly more difficult is to explain why the trend should now be reversing. We would see three reasons:

Sub-contracting may be approaching its limits, not that it will decline, but most of it has already happened
Asian costs are themselves rising with wage inflation
The share of services in developed economies is increasing, including untradable services, which cannot be sub-contracted and which are not therefore subject to Asian competition.

Wage inflation frightens central bankers.