If the labour market is supposedly so tight, why has wage growth remained so tame?

Written by Adam Chester, Head of Economics, Commercial Banking, Lloyds Bank  

CONVENTIONAL economic theory says that when employment levels are high – as they are now in the UK – wage and price inflation pressure starts to build, prompting policymakers, such as the Bank of England, to tighten monetary policy by raising interest rates.

Yet, in recent years, the UK unemployment rate has fallen to levels historically associated with rising pay, but remuneration growth has failed to gain traction. The so-called ‘Phillips Curve’, which suggests the lower an economy’s rate of unemployment, the more rapidly wages increase, appears to no longer be the case.

Why the labour market remains so strong and wage growth so weak is a key question for policymakers. Mark Carney suggested that the Bank of England would consider raising interest rates when the unemployment rate fell to 7%.  That was nearly three years ago.  Since then, the unemployment rate has fallen to a 10-year low of just 5.1%, while the number of people in work has risen to above 31.5 million – a record high.  Job vacancies have reached nearly 750,000. If these were filled by those out of work, the adjusted unemployment rate would be just 2.8%, its lowest since 2004.

But, if the labour market is supposedly so tight, why has wage growth remained so tame?  

There are a number of possible reasons.  It may be that heightened economic insecurity and weak global inflation have impaired employee bargaining power.  It may also be that poor productivity and the resulting squeeze in corporate earnings means companies cannot afford to pay more.

Headline remuneration figures may also be disguising more subtle trends.  There is evidence that rising skill shortages and the implementation of the living wage have driven up pay for high and low wage earners, while those on a middle-income have seen their pay squeezed.

There are a number of reasons why there appears to be this fundamental shift in the structure of the UK economy, allowing permanently lower levels of unemployment without stimulating inflation.

But fundamentally, the supply of labour has increased. The active portion of the economy’s labour force, aged 16-64, has risen to a record high of 78.3% in recent years, and to 63.6% for all those aged 16 plus.

Various influences have driven this ‘participation rate’ higher, including an ageing population, tighter disability benefits and rising immigration.  Since 2000, the proportion of those aged 65-plus that are economically active has more than doubled to just over 10%, while the number of immigrants employed in the UK reached 3.2million at the end of last year, of which two million were non-UK, EU nationals.  Indeed, nearly half of the growth in employment last year was accounted for by foreign nationals.

The proportion of those aged 65-plus remaining in employment has plenty of scope to rise further, especially given the uncertainty surrounding future pension provision.  Furthermore, changes in the way disability and other social benefits are awarded might lead to a continued fall in number of people who are economically inactive due to long-term sickness.

Not only is there scope for the number of workers to rise, but also the hours they work. Having fallen sharply in the late 1990s and early 2000s, average hours worked have started to rise in recent years.  Eight million of the UK’s workforce are currently employed part-time, including those on zero hour contracts.  At least some of these are likely to be content to work longer hours if asked to do so.

It remains to be seen how far UK unemployment falls before increasing wage pressures really kick in.  The answer has important implications for all areas of UK economic policy – not least whether, or by how much, UK interest rates may ultimately need to rise.