Economics - Every silver lining has a cloud.

(From Financial Director)

Byline: Dennis Turner, chief economist at HSBC.

Despite the fact that inflation has edged down this year, the Monetary Policy Committee still raised base rates in May and implied there was more to come. The move was widely expected and caused no great surprise in the City, which now accepts that policymakers have moved away from a literal interpretation of their terms of reference. Concerns about house prices and personal borrowing seem to weigh at least as heavily as consumer price prospects in the Committee's interest rate decisions.

The Bank does have some worries about prices, though. With all the indicators of domestic activity (including manufacturing output) pointing upwards, conventional economic thinking suggests that faster output growth will convert to faster inflation once the spare capacity in the economy has been absorbed. Some MPC members believe that, even when demand was running below trend last year, the amount of capacity available was uncomfortably low and that it would take only a modest increase in activity for price pressures to re-emerge.

A key measure of spare capacity, and a traditional source of inflation, is the labour market. In the past, as the economy expanded and unemployment fell, pay settlements moved up, and higher wages led to higher costs and still faster inflation. Over the past decade, the UK economy has seen a substantial growth in employment and a fall in the jobless total. But could this remarkable success undermine the stability which created it?

That the UK labour market has been transformed since the dark days of the 1970s is beyond doubt. The most commonly quoted measure of unemployment, the number claiming benefit, is now below 900,000. This is the lowest since 1975 and comes just 10 years or so after the low point of the last recession, when the total was pushing up towards three million. As a share of the labour force, unemployment is now down to 2.9%. Using a different European measure, the Labour Force Survey, the UK jobless rate is just under 5%, with France, Germany and Italy all at around the 9% mark.

This trend obviously reflects a surge in employment. The latest figures show there are 28.3 million people in the UK in employment, a jump of almost 200,000 on the previous three months and ...