Which will crack first - wages or prices?

Never mind the 1980s, you have to go back to the Labour government's income policies of 1977 to find a time when household incomes have been as squeezed as they have been in the past year.

Both the government and the Bank of England are implicitly assuming that households will continue to take their medicine, with wages rises falling far short of tax and price rises for at least another two years, and inflation obediently falling back to target in 2012. But you don't have to be an inflation hawk to wonder whether it is likely to happen now. After all, it's not what happened in the late 70s, the early 80s, or the early 1990s.

Believe it or not, many would argue that a prolonged squeeze in household incomes was the "best case" scenario, starting from where we are now, because it spreads the pain of adjusting to a more inhospitable global economy as widely as possible. If wages pick up, interest rates would have to rise further, sooner, to bring inflation under control. Unemployment would be higher, perhaps permanently; growth would be slower, and the costs of this adjustment would fall disproportionately on public sector workers (whose pay is frozen) and all those unemployed workers who find it even harder to find a job.

Those new GDP figures I mentioned yesterday showed real household disposable income falling by 0.8% in 2010. That's the first time this measure has fallen since 1981. As Graham Turner of GFC Economics has pointed out, it's also the largest annual decline since 1977, when phase two of the Labour government's incomes policy was capping incomes growth to combat inflation.

At that time, monetarists like Milton Friedman used to publicly lecture Labour ministers that they were making the situation worse: income and price controls only repressed inflation, they didn't get rid of it. And in that case, he was right. The income policy fell apart, collective bargaining resumed, and both nominal and real disposable incomes rose sharply in 1978 and 1979 to make up for lost ground.

Will we see the same kind of explosion in pay in 2011 or 2012? The monetarists would certainly not expect one, looking at the still weak state of lending and money growth. It's not easy to see in the wage data either. The latest survey from IDS (chart attached) shows wage settlements running well below inflation. The median deal reached between December and February was for a pay rise of 2.5% - very similar to last month.

There are some warning signs in the small print of this month's report. Pay rises in the private sector are running at 2.9%, and the IDS note that most of the April deals it has recorded, not yet included in the three-month rolling average, have been for wage rises of 3% or higher.

The MPC are likely to be poring over those April pay deals as they start to come in, setting the context for the great debate over rates at their meeting in May. The chances are that private sector wages will continue to creep up. But it is also the case that the public sector pay freeze will put downward pressure on average earnings for the whole economy. And as we know, inflation is only one part of the squeeze for households.
In the past I've highlighted the broader TPI measure of the cost of living, which includes not just price rises but tax changes as well. That rose by 5% in 2010, and now the latest figure, for February, shows a year on year increase in costs of 6%. Using that broader measure, even a 3.5% pay rise in 2011 would still represent a sharper fall in real incomes than in 2010.

For some, this squeeze in real incomes poses a bigger risk to confidence and the economic recovery this year than government budget cuts (although, of course, the decision to raise VAT has made its own contribution to the rise in prices). The doves on the MPC are betting that another year of economic hardship will be more than enough to bring down inflation next year. But only Adam Posen is putting his money where his mouth is: in an interview earlier this week he said he expected inflation to go to 1.5% in the second of half of 2012, and he would not seek another term on the committee if he turned out to be wrong. In theory, we should all hope Posen's right about inflation. But then he might also be right about the grim state of the economy. I'm not sure if I want him to go or stay.