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Letters exchanged between the governor of the Bank of England and the Chancellor of the Exchequer last week following release of the May CPI inflation rate figure, highlight the importance of ensuring that pay settlements do not accelerate in response to an increase in the cost of living.

John Philpott, chief economist at the Chartered Institute of Personnel and Development, said that the economy is unlikely to experience an old-style wage-price spiral, but agreed that average pay rises must remain modest to offset a substantial rise in unemployment.

He said: "The code in Mervyn King's letter to Alistair Darling is that, come what may, British workers will have to accept a significant squeeze in living standards in the coming months. If this does not emerge through below inflation pay settlements the pain will be felt in the form of a more significant economic slowdown and a bigger rise in unemployment than already is on the cards. In other words, if there are inflation matching pay hikes, the consequence will not be a damaging pay-price spiral of the kind the economy experienced in times past, but instead fewer jobs.

"The good news is that there is little sign of mounting pay pressure in the economy. Compared with previous eras when trade unions were significant players in the private sector, and pay often automatically followed increases in living costs, employers are better able to keep pay rises in check even when inflation is rising. However, it is vital that restraint is maintained in this current period of sharply rising fuel and food prices."