The economic recovery gained momentum in 2014, though it failed to feed through into raised living standards as much as many hoped. There are reasons for being fairly optimistic that this could start to change next year. Underpinned by the buoyant jobs market we expect household disposable incomes – the best measure of living standards – to increase steadily, returning to the levels of growth last seen in the mid-2000s.
However, this welcome improvement is unlikely to make up for the ground lost over the course of the downturn – we do not expect a return to pre-crisis levels until early 2016, nor do we anticipate a burst of ‘catch-up’ growth to compensate for the recent years of stagnation.
Furthermore, the increases that we expect to see are likely to be over-stated in the official, widely reported, and rather misleading national account figures (hence the Resolution Foundation has recently developed its own measure that seeks to adjust the official statistics). A mix of different forces lie beneath the headline figures – some benign, others less so – that together will make up the economic weather and shape living standards in 2015.
Five rays of sunshine…
Falling unemployment – how low can you go?
The speed with which unemployment has fallen has been one of the great success stories of the past two years. Little more than a year since the Bank of England specified a 7 per cent unemployment threshold as being the point at which it would re-assess its monetary stance, the rate now stands at 6 per cent.
The OBR projects that it will fall to 5.4 per cent in 2015, taking it to roughly the level the Bank now thinks forms the ‘natural’ rate of unemployment or NAIRU. But this assessment has already been revised down and one of the big questions for 2015 is whether unemployment might fall again back to the levels it was at pre-crisis, with some even thinking that in future years it could go lower still, towards levels not seen since the 1970s.
We’d also expect to see employment levels rising further. Labour market flexibility, the cumulative impact of over a decade of welfare reforms, pension inadequacy (associated with rock bottom interest rates) and financial pressures linked to stagnant incomes and high household debt are all likely to help nudge the employment rate upwards. In 2015 it is likely to be at or above the peak of the 2000s, and the post-crisis ‘jobs gap’ should close in nearly all regions and nations of the UK.
Wages – staying positive
Official projections from both the OBR and the Bank of England are for a return to real pay growth in 2015. They have of course predicted pay growth ‘tomorrow’ throughout this Parliament but, with unemployment still falling and pay inching upwards, the signs are they might be right this time around.
The unexpectedly poor performance of 2014 was partly due to a shift in the make-up of the workforce towards lower-paid groups and sectors. It’s very likely that at least some of these compositional changes – especially those relating to the rapid growth of younger and less experienced workers – will tail off next year, meaning that real wage growth will stay positive.
In addition, more people are starting to move from job to job – reflecting growing confidence about prospects – which tends to be a leading indicator of upward wage pressure. Higher business investment may even start to feed through into at least some productivity growth, and the expectation is that after such a long wage squeeze, at least some of these gains would be passed on to workers’ pay packets.
Low inflation and interest rates – on the floor
Having been more than one percentage point above its target for 39 months out of 49 from April 2008, CPI inflation has fallen steadily over the last two years and now stands well-below target at one per cent. The ongoing supermarket price war and tumbling oil prices started to bring down the cost of essentials this year. These prices shifts are likely to persist for some time in 2015 and help make it more likely than not that the Governor will have to write a letter to the Chancellor as a result of low inflation. The OBR is projecting that inflation will rise only slowly throughout 2015, not returning to its two per cent target until 2017.
While there are significant risks to lower inflation, there are clearly upsides too. It should help to ensure that potentially small improvements in nominal pay growth flow into at least some real-terms gains, easing the pressure on households after a six-year pay squeeze. It will also reduce the pain for those whose benefits are being uprated at one per cent. And low inflation will also reduce the likelihood of significant increases in the Bank of England’s base rate, with the first rise not now expected until the second half of 2015 at the earliest and quite possibly not until a year from now. This will provide relief for many households still burdened with a large debt legacy built up in the pre-crisis years. The combination of real wage rises and low mortgage rates will offer households more space to prepare themselves for the eventual rise in borrowing costs.
A rising minimum wage – back to normal?
The National Minimum Wage (NMW) outpaced prices for the first time in six years in 2014. With the Low Pay Commission indicating we have now entered a “new phase” in the NMW’s history, 2015 should bring another welcome real-terms boost to the wages of 1.2 million NMW workers. The effects should be felt further up the earnings scale too given that almost one in three employers use the NMW increase as some sort of benchmark in their annual pay round. We’d expect to see a hike in the NMW in 2015 of at least the same size as 2014 (three per cent), most likely higher.
The main political parties engaged in something of an arms race over the NMW in 2014, and that is likely to play out again in the manifestos and run-up to May. Pre-election positioning and concerns about wage falls over the Parliament might also mean that 2015 is the year the Living Wage campaign comes of age – converting its widespread appeal into a far greater reach across the low paid workforce.
Pensions – auto enrolment reaches small firms
With all eyes on the Chancellor’s big shake-up of the annuities market starting in April, many may overlook another important pension story. Over 150,000 SMEs have their staging date for auto-enrolment in 2015-16, a step up from the 43,000 employers to date. In just the first six months of 2015, 160,000 employees are estimated to be eligible to join the five million from larger firms who have already been auto-enrolled.
Extending the scheme to smaller businesses will not be without its challenges; the opt-out rate may increase from the better than expected one-in-ten average seen so far. But reaching more workers in small firms will help to close the gap in workplace pension coverage between staff at small and large firms as well as being another step on the road to ensuring that more people have adequate savings for retirement.
…and five dark clouds
Wages – no catch-up in sight
Although we expect a return of headline pay growth in 2015, the pace of improvement is likely to remain highly subdued. The surge of younger and less-experienced workers into the labour market may tail off, but the underlying shift towards lower-skilled occupations seen in 2014 could well persist in 2015. If so, there would still be a compositional drag on pay growth. And even with steady growth it will take some years before pre-crisis pay levels are reached – don’t expect that before the end of the decade. And, while the roll-out of auto-enrolment to many SMEs is good news for the many workers with inadequate pension pots, it is likely to create further pressure for pay restraint among smaller employers. 2015 may well, belatedly, be the ‘year of the pay rise’ – but for most it will be a modest one.
Jobs – further into a two-tier jobs market
The gulf in the labour market between so-called ‘lousy and lovely’ jobs shows little sign of being bridged in 2015. Despite the tightening labour market, expect zero-hours contracts – 1.4 million contracts do not guarantee a minimum number of hours – and other growing forms of insecure employment to feature prominently in debates around whether the recovery is being shared. Those moving in and out of insecure work have also experienced very large pay cuts while those who’ve stayed in continuous employment for longer have fared significantly better. When it comes to the jobs market we’re not really all in it together.
Wage inequality between high and low earners will be another one to watch in 2015. It has been broadly flat since the downturn but the pattern in previous recoveries has been for inequality to rise as wage growth builds. Don’t be surprised if this happens again.
Productivity – any sign of life?
The outlook for productivity growth – the biggest question of all – remains particularly unclear. The OBR has described it as the “most important uncertainty” in its forecast. Strong productivity growth would boost wages, incomes and government tax receipts. Equally, weaker than expected productivity growth would damage the prospects of pay recovery. The OBR identified a £58 billion fiscal difference by 2019 between a scenario in which productivity continues to disappoint and one in which the strong growth of the early-1980s was to prevail.
A continuation of the current pace of reduction in unemployment in 2015 and the presence of a lower-than-estimated NAIRU would dampen the potential for productivity growth and darken the fiscal outlook. Medium-term wage recovery would be similarly limited.
Austerity – it’s back
The scale of further spending cuts, tax increases and borrowing in the next parliament will of course depend on the May election as well as on productivity growth. But there are many cuts already scheduled that will have an impact this year regardless of the election outcome and the clear expectation is that the pace of deficit reduction will accelerate in 2015-16.
Departmental budgets in the year from April will be around £8 billion lower in real terms than in 2014-15. Welfare cuts will continue to squeeze low income households. In particular, tax credits are set to rise by only 1 per cent for a third year (with real cuts to Universal Credit continuing for several more years), reducing support for low income working families. That said, below-target inflation will lessen the impact (and associated savings) of these benefit cuts, though the impact on those living close to the edge will still be substantial. Many councils will also be further cutting back on Council Tax Support in 2015-16 – expect the temperature to go up on this issue in 2015.
We’ll also see a further increase in the income tax personal allowance (to £10,600) come into effect in April, along with the new marriage tax break, and “tax-free” childcare in the Autumn, benefiting millions of tax-payers – though the clear majority of these gains will flow to the richer half of households.
Personal debt – hair of the dog?
While low interest rates are welcome in reducing the immediate burden on indebted households, they raise the risk that already-stretched households are encouraged to take on new debts that they may struggle with when interest rates eventually rise. The continuing mix of weak pay growth and reduced welfare support, alongside a reduction in government borrowing and rising house prices, means that household borrowing is likely to be a prop for steady growth.
Despite the income squeeze, the ratio of gross household debt to income has been lower in the second half of this year than at any time in the past decade. But the latest OBR projection suggests that the household debt burden will now start rising, reversing the deleveraging of recent years, and eventually increasing far beyond its pre-crisis high. In part this reflects rising house prices, but it is also based on an expected spike in unsecured lending such as via credit cards. The saving ratio is projected to be lower in 2015 than in any of the years from 1997 to 2014. These forecasts have been wrong before, but the degree to which the post-crisis recovery will be driven by household borrowing and consumption will be one of the key trends to watch next year.
 The difference between the current employment rate and its level in May 2008