Belfast Telegraph

It's a pity but no surprise that wages aren't increasing with inflation

Economy Watch

By Conor Lambe, Danske Bank economist

The UK economy is experiencing a slowdown. In the first quarter of this year, real GDP grew by just 0.2%. In the second quarter of the year, economic growth was a modest 0.3%.

One of the main factors behind this low growth is the squeeze on consumers - a consequence of high inflation and falling real wages.

In Great Britain, the latest data shows that nominal wages grew by 2.1% in the year to April-June 2017. However, inflation currently stands at 2.6%. Therefore, when price rises are taken into account, consumers' earnings are actually decreasing.

The high rate of inflation is pretty easy to explain - it's mainly a consequence of the depreciation in sterling following the EU referendum. But, given the apparent strength of the labour market, why is wage growth so subdued?

Economic theory suggests that a strong, or tight, labour market should result in wages rising relatively quickly. From the beginning of 2003 to the end of 2007, the five years preceding the financial crisis, the UK economy and labour market performed pretty well. Nominal wage growth averaged just under 4% during this period. So perhaps the first thing to examine when considering the current rate of wage growth is just how tight the labour market really is at present?

The measure that receives the most attention when assessing the performance of the labour market is the unemployment rate. In the UK, the unemployment rate is 4.4% - the lowest since 1975 and 0.7 percentage points lower than the 5.1% that it averaged from 2003 to 2007. However, analysing some other data sources can help to build up a clearer picture of the jobs market.

The UK employment rate is the highest since comparable records began in the early 1970s and there are currently 1.9 unemployed people per job vacancy, lower than during the pre-crisis years. However, 12.3% of people working part-time are doing so because they can't find a full-time job - higher than the 8.4% averaged from 2003 to 2007.

And the proportion of people in temporary employment because they couldn't find a permanent job is also a bit higher now than it was in the mid-2000s.

This closer look at the data suggests there may be a little more slack in the labour market than the headline numbers suggest, and this could be restricting wage growth. But, on its own this is not enough to explain why the current rate of earnings growth is approximately half of what it was before the financial crisis. I think there are two other factors holding back wage increases - Brexit-related impacts and weak productivity growth.

For many businesses, the depreciation in sterling following the EU referendum has pushed the price of imported raw materials upwards. This has put costs firmly under the spotlight and, as such, some companies are reluctant to take on the additional cost of significantly higher wages, even if workers ask for pay rises to match the higher inflation rate.

As well as this, considerable uncertainty remains around what access UK businesses will have to EU markets after Brexit occurs. When coupled with the slowing domestic economy, the risks around future revenues are relatively high and this may also be leading businesses to hold off on offering permanent pay rises to their staff.

Labour productivity growth is a key determinant of wage rises. Productivity is defined as the amount of output a worker produces in an hour. When the amount that each worker produces is rising quickly businesses are more able, and willing, to offer high pay rises. However, UK productivity growth has been weak for a number of years now. Productivity fell in the first and second quarters of this year and output per hour is currently lower than it was in the fourth quarter of 2007. Unless productivity growth picks up strongly, it is hard to see wage growth returning to its pre-financial crisis levels.

Boosting earnings growth is not straightforward but there are some actions that policymakers could take to combat the two factors holding back wage rises that are discussed above.

Resolving the separation issues related to Brexit, specifically around the financial settlement which appears to be the biggest stumbling block at present, would allow the UK and EU negotiators to move onto discussing future trade terms. The UK Government should do all it can to ensure that the separation terms are agreed by the original October deadline.

It should also quickly seek to reach an agreement with the EU for a transition deal that will maintain access to EU markets for UK businesses while the future trade deal is negotiated and finalised. This could reduce some of the short-term risks for businesses and make it easier for them to grant wage increases.

Raising productivity growth is a longer-term challenge and will require policies to improve the UK's existing infrastructure, investment in skills and measures to encourage businesses to innovate and engage in Research & Development activities. The Government has already announced policies along these lines - for example last year's Autumn Statement had an infrastructure focus while this year's Budget included a number of education initiatives. If policymakers are to succeed in raising productivity growth, these things need to remain high on the Government's policy agenda.

Inflation is forecast to remain above the Bank of England's target over the next couple of years. With continued high price rises on the horizon, consumers are no doubt hoping that wage growth starts to pick up sooner rather than later.

Belfast Telegraph

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