Falling price pressures, more than falling vacancies, are set to drive smaller pay rises next year

Strong pay growth in Britain may cool next year, driven more by workers’ experiences of lower inflation than a looser labour market, according to new Resolution Foundation research published today (Tuesday).

The latest Labour Market Outlook examines a key question for policy makers and workers coping with the cost of living crisis – what will happen to pay growth in the year ahead.

Nominal pay growth in the private sector hit a record high of 8 per cent in the three months to August this year, more than double the rate seen in the years running up to the pandemic of 3.4 per cent. This is a concern for policy makers as it could fuel inflation and keep prices higher for longer.

The tightness of the labour market has been the key factor cited as driving this high wage growth. High job vacancy levels and low unemployment has put pressure on firms to increase pay, in order to recruit and retain staff.

The research finds that sectors where worker shortages are biting most have seen the strongest pay rises. A ten percentage point increase in the share of firms in a sector who report workers shortages is associated with a 5.7 percentage point rise in the share of firms in that sector that give workers a pay rise.

However, the labour market has become looser in recent months – the number of job vacancies has fallen for 16 consecutive months, payrolled employment growth has slowed, and fewer firms are reporting worker shortages.

While this loosening should slow pay growth, the Foundation’s analysis shows that the effect can be small, and builds gradually over time. This presents a dilemma as it would require considerable labour market loosening – meaning far higher unemployment – in order to normalise pay growth levels and reduce inflation in the current economic climate.

The research also notes that as well big pay rises being a cause of inflation, they are also a response to it, and that this relationship should have a bigger and more immediate effect on pay growth next year.

The report – which also uses data from a new YouGov survey of 8,378 people – finds that of those private-sector workers who received a pay rise last year, over two-in-five (43 per cent) thought the increase was due to cost of living pressures, compared to just 15 per cent who thought it was due to recruitment and retention challenges.

This is reinforced by recent Bank of England research, which found that inflation expectations accounted for over half (53 per cent) of nominal pay growth this autumn, with labour market tightness contributing just 13 per cent.

With inflation falling back rapidly in recent months – it fell to 4.6 per cent last month, its sharpest annual fall in four decades – the Foundation says that this should help cool pay rises too. This would be a far less painful way to get inflation down – requiring a smaller rise in unemployment than might be the case otherwise.

In fact, the Foundation finds that there are already some signs of pay growth slowing on short-term measures (the headline rate is measured in annual terms). If pay growth continues to slow at the rate it has done for the past four months, it would fall to 4 per cent by March next year – a level of pay growth far more consistent with lower inflation.

Hannah Slaughter, Senior Economist at the Resolution Foundation, said:

“Pay growth reached a record high of around eight per cent last summer. This has offered some workers respite from cost-of-living pressures, but by keeping inflation higher for longer it risks making the crisis harder to end.

“Economists often point to the tightness of the labour market as a key driver of wage growth. But while true, its effect is relatively small and takes time. Instead, workers’ views on cost of living pressures have had a far bigger effect on pay rises.

“The big recent fall in inflation should ease the pressure on pay settlements, and help to bring about more normal wage rises and price increases next year. Ultimately, Britain needs to get back to delivering productivity-based pay rises, rather than inflation-inducing ones.”

Notes to Editors

The figures on workers’ reported reasons for pay rises over the past year use data from an online survey of 8,378 adults aged 18+ conducted by YouGov, and supported by the Health Foundation. Fieldwork was undertaken between 13-17 October 2023. The figures have been weighted and are representative of all UK adults (aged 18+). The figures presented from the online survey have been analysed independently by the Resolution Foundation. The views expressed here are not the views of YouGov.