Building on Britain’s living standards recovery next year will require decisive action by policy makers

British policy makers might well have had a contented Christmas break. At least by recent standards.

In 2015 employment reached record highs while real earnings growth returned after a six-year absence. Crucially those on the lowest earnings saw the biggest rises at over three per cent.

But policy makers from the Treasury to the Bank of England should be wary of too relaxed a break. 2016 looks set to ask many more questions of them than the previous 12 months.

From making further progress towards full employment and ensuring real earnings growth strengthens, to navigating a complex monetary landscape, the year ahead offers less scope to rely on tailwinds to build the living standards recovery we want to see.

Indeed in many areas 2016 will be decision time. Let’s look at the three stand-out issues policy makers will need to grapple with that matter most for living standards.

‎‎‎Full employment

First, achieving full employment. This is now a formal and welcome goal of government policy. The last few years have seen impressive progress towards it. Employment has risen faster than history gave us any reason to hope for and at over 73 per cent is now the highest since records began in 1971.

The government deserves some credit for this. But the main lesson is that a more flexible labour market built over 30 years proved a much bigger boost to job growth in the recovery phase of a recession than expected. You might call this the boon from policy makers past.

Cautious policy makers should not now be simply counting on that boon delivering indefinitely.

Further falls in unemployment are unlikely to play the same role in boosting employment next year as they have done recently. Unemployment at 5.2 per cent is now very close to the equilibrium level that the Bank of England considers consistent with stable wage growth.

There is more scope for individuals to take on more hours, but making further progress on employment toward leading countries like New Zealand and Sweden requires increases in underlying labour supply. We will need to address some of the stubborn structural weaknesses of our labour market.

This will require a more a more active role for policy makers – not something we are on course to see with the replacement for the Work Programme being stripped back to focus on the most long term unemployed. Welcome promises of a greater local role in that replacement alone are not going to see large boosts to employment.

More ambition on part time job quality, alongside simpler childcare support, could help to further close the 10 per cent employment gap between women and men. Unacceptable regional variations for low participation groups including disabled people and ethnic minorities also provide stark reminders of the need and potential for progress. These areas and more will be central to major Resolution Foundation research published in the New Year.

Pay

Second, pay. Since it was created the OBR has consistently promised pay growth next year, only to be disappointed. Luckily for them, and all of us, it actually turned up in 2015.

This was in no small way related to the fact that we have imported zero inflation for the last 10 months on the back of huge falls in the global oil price since July 2014 and a stronger pound. Petrol below £1 is no longer some historical feature we all talk of wistfully, but a reality on some forecourts.

Nominal pay also rose on the back of a tightening labour market, accounting for a little over 40 per cent of the rise in real earnings in 2015 against over half from lower inflation on the basis of the OBR’s forecasts.

But both the benefit of imported falling inflation and the automatic earnings boost from a tightening labour market are unlikely to be repeated in 2016. The labour market has less slack to lose and CPI inflation is forecast to rise to over 1 per cent.

Instead achieving faster real earnings growth rests on productivity doing more of the legwork. And that in turn means hard legwork for policy makers – not least on skills gaps, the failure of innovation to trickle down to a wider range of firms, and the woeful housebuilding that hold back British productivity.

There is reason for optimism that pay inequality will fall again in 2016 as a result of the National Living Wage (NLW) being introduced. But 2015 saw the easy part of that policy – its announcement. The focus in 2016 moves to the trickier aspects – its implementation. We need more urgency from the government in working with sectors, like retail and cleaning, that will find that a challenge and where investment to deliver productivity gains will be crucial.

Interest rates

Third, interest rates and monetary policy more generally saw an almost entirely inactive 12 months, against market expectations this time last year.

But as 2016 dawns there are changes afoot. If nothing else policy inaction will need to be a more active choice next year. That is partly because we should expect rising anxieties about rates remaining so low that they could hardly be cut if another downturn struck.

But more importantly the Federal Reserve’s decision to increase rates has raised the stakes. There are good reasons, including stronger US economic growth, for thinking that the fundamentals justify diverging monetary policy for the UK and US. Indeed market expectations are now for the first UK rate rise to only take place at the start of 2017. But the political economy of the debate means people will be asking how wide the Atlantic gap can get before Threadneedle Street feels it needs to show it can act.

Seven years of unprecedented action by the Bank has brought welcome breathing space for millions of stretched households that took on serious debts before the crisis. Improvements in their finances during that time has meant reductions in the number of households that would be seriously exposed to rate rises, but there are still a disproportionate number of low income households that would find rate rises hard to manage. So the sense that we are witnessing the beginning of a tightening cycle should reinforce how important the distribution of income gains in what remains of the breathing space is to debt affordability.

2016

On living standards 2015 amounted to something of a collective sigh of relief, but 2016 will ask more of us from addressing some of the underlying weaknesses in our economy to charting a challenging monetary course. It might have been a relaxing Christmas – but it should be an active New Year.