UK wage strength remains a conundrum for economists and a pressing issue for Bank of England policymakers.
Despite a surge in inflation, widespread labor shortages, and public sector strikes, average nominal UK earnings reached a record high of 8.3 percent in the summer of 2023. However, the economy has since stagnated, job vacancies have decreased, and employers have slowed down hiring. Productivity, a key factor in determining wages, has been on the decline since 2023.
Nevertheless, average earnings for the three months leading up to January were still 5.9 percent higher than the previous year, outpacing inflation for over a year and a half.
While larger paychecks benefit households financially, they also raise concerns for the Bank of England, as current wage growth rates are seen as inflationary without a boost in productivity.
Understanding the underlying factors driving this wage growth trend is crucial for shaping future interest rate policies.
Is wage growth sustainable?
The Bank of England’s Monetary Policy Committee downplayed the latest wage data when announcing its decision to keep interest rates steady at 4.5 percent. The committee noted that the 6.1 percent increase in private sector average weekly earnings was influenced by sectors where pay growth tends to be volatile. Other indicators aligned with the BoE’s estimate of underlying wage growth slightly above 5 percent.
However, the MPC cautioned that wage growth is currently elevated and exceeds what can be explained by economic fundamentals.
The committee highlighted two main risks leading up to its May meeting: the potential for persistent domestic wage and price increases and geopolitical tensions triggering a deeper economic downturn.
Will wage growth taper off?
Recent data suggests that wage growth is likely to slow down in the coming year. The BoE’s surveys and data from Brightmine predict pay increases of 3 to 4 percent for existing staff in 2025. Some employers may reduce pay awards by 1 to 2 percentage points to offset higher payroll taxes starting in April.
However, Chief UK Economist Rob Wood from Pantheon Macroeconomics believes this would still result in earnings growth above 4 percent on the ONS measure, which could fuel inflation without a simultaneous increase in productivity.
What’s behind the wage growth?
One potential factor contributing to wage growth is the significant hikes in the statutory minimum wage. Retailer Next and others have warned of a “ripple effect,” prompting higher wages for employees further up the pay scale to maintain incentives for career progression.
A shift in job composition within the economy may also play a role. Recent data indicates a decline in low-wage retail employment and an increase in professional and financial services roles.
However, Senior Research Economist Xiaowei Xu from the Institute for Fiscal Studies suggests that these factors only explain a small portion of the disconnect between wage growth and economic conditions.
BoE Governor Andrew Bailey’s suggestion that productivity growth may not be as dire as reported has been met with skepticism among economists.
Why is the BoE concerned?
The primary worry for the Bank of England is the possibility of a structural shift in the UK economy, where wages grow at a sustained rate of 3.5 to 4 percent annually, and inflation remains near 3 percent.
Chief UK Economist Rob Wood argues that this scenario is already unfolding, and policymakers are underestimating the significant increase in household inflation expectations over the next five to ten years.
Households have come to anticipate the Bank of England allowing inflation to surpass the 2 percent target indefinitely, leading to a shift in economic norms.
Why is consumer spending lagging?
An additional puzzle arises from the lack of significant boosts in consumer spending despite real wage gains. Retail sales and overall household consumption remain below pre-pandemic levels, with a high proportion of income being saved.
Analysts predict that spending will rise as households rebuild their savings depleted during the pandemic. However, concerns about rising costs of essentials, job cuts, and trade uncertainties continue to weigh on consumer confidence.
Economist Sandra Horsfield from Investec highlights the potential impact of increased defense spending and trade tensions on consumer sentiment and overall economic outlook.
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