Labour market Labour market loosens gradually as inactivity falls, but pay growth remains high 11 July 2023 by Greg Thwaites Greg Thwaites Today’s data paints a picture of a labour market that is loosening somewhat (as in, firms aren’t having to compete quite as fiercely for workers) but with pay growth at levels still far too rapid to hit the Bank of England’s 2 per cent inflation target. Real pay is still falling, so we’ve taken a look at the factors driving it. Good news: labour market inactivity keeps falling, especially among men Let’s start with the good news. The labour force has continued to expand as more inactive people have returned either to work, or to looking for it. Inactivity fell by 0.4 percentage points on the quarter, split evenly between a rise in employment and unemployment. This recovery has been driven by men, although their employment rates remain further below pre-pandemic levels than women’s employment rates. Along with a fall in vacancies (250k fewer over the past year), this means that the labour market is loosening on most measures. When compared to pre-pandemic norms for the vacancy/unemployment ratio, the UK labour market is now looser than in the euro area. (See below for some more international comparisons). Awkward news: nominal pay still growing fast, real pay still falling Pay growth remains strong: average weekly regular pay grew by 7.3 per cent in the 12 months to May 2023. Looking at higher-frequency pay rises, three-month annualised pay grew by 9.2 per cent in the private sector, while public sector pay has flattened off (see chart). The recent above-average rise in the minimum wage could be contributing about 0.5 percentage points to annualised pay growth in May. These rates of pay growth are generally much faster than pre-pandemic rates and substantially outside of the Bank of England’s comfort zone. Either the past tightening in policy or recent loosening in labour market quantities have yet to take full effect, or interest rates are going up again. But, in line with the pattern of the recent months, real pay is still falling – regular real pay fell 0.8 per cent in the three months to May, compared to the previous year. In the next section we talk about how the economy can get back to sustainably generating real pay growth. Paying for pay growth Pay growth can generate inflation because it forms part of firms’ costs. Other things equal, when pay rises, firms’ costs rise and they have to charge higher prices to cover them. The higher prices put workers’ pay back to square one in real terms. But other things are not always equal. There are three broad ways to break the link between pay growth and subsequent price growth. First of all, workers can become more productive, producing more per hour or per head so that firms’ labour costs per unit of output do not increase. In the long run, this is the main reason why the purchasing power of wages is higher in the UK today than in most other countries, or than it was here a century ago. But the past few years have been atrocious for productivity growth, and UK productivity actually fell in the five post-pandemic quarters between 2021Q4 and 2023Q1 (see chart below). See our recent report on business investment for some ideas about how to boost productivity growth. Secondly, firms can see falls in their other variable costs (such as imports) or charge overseas customers higher prices. (This latter point is one reason why it can be good to export services, whose prices tend to rise over time, as I’ll set out in a forthcoming blog). We can measure these ‘terms of trade’ crudely with the price of GDP relative to the consumption deflator. The chart shows that this factor has been pushing down on real wages recently as imported energy and food has risen in price. Thirdly, firms can pay their workers a bigger share of their value added. (The full picture is more complicated than this and is covered nicely in Jonathan Haskel’s recent speech). There are limits to how far this can go – ultimately the labour share cannot rise beyond 1, and has been not exhibited a trend in the UK for the past two decades. The chart below shows how these factors have played out during the pandemic and the post-pandemic period, and overall, in the US, UK and euro area. To facilitate international comparisons, the data mostly stops in 2023Q1, and the wage measure is ‘labour compensation per employee’ from the OECD, different to the ONS data we narrate above. The chart shows that the UK experienced an unfortunate combination of factors creating inflationary pressure and pushing down real wages – higher wage inflation than the euro area, but equally bad productivity growth and as much pressure from the terms of trade. The labour share has fallen slightly in the most recent quarters in the UK but overall since 2019Q4, and in contrast to the US and euro area, has pushed down on inflation. We’ll look more closely at an international comparison of different components of inflation next week. For now, the takeaway is that the UK’s atrocious real wage performance is down to a combination of external (terms of trade) and home-grown (productivity) factors, in common with the euro area, but with the erosion of real wages taking place more through higher prices.