Wage Inflation in the UK: What’s Going On?
Why do economic commentators, financial markets,and central banks obsess about inflation? Why is there limited wage inflation whilst there is very low unemployment?
In the 1970s, higher oil prices meant the cost of living rose. This was from the direct impact of higher energy bills, and indirect effects as the cost of producing and shipping goods rose. As a result of the higher cost of living, people asked for wage increases to maintain their standard of living. This meant that labour costs rose, pushing the cost of goods and services even higher. This, in turn,fuelled further inflation, so inflation persisted and people asked for more wage increases to be able to afford the same living standards.
Inflation provokes a need for higher wage increases to maintain living standards, and this, in turn, creates further inflation in goods and services, which provokes more requests for wage increases. It is fear of this spiral effect and its impact on the economy that made inflation a focus in the 80s and 90s. It is not really inflation itself, but the resultant secondary round wage inflation that creates concerns around inflation.
In the end, the solution to avoiding this upward spiral in the cost of living and wages was to end the period of high inflation via abnormally high (double digit) interest rates. This level of interest rates was an anomaly in most countries in the developed world. In the UK, the 400-year average interest rate is around 4,0% to 4,5%. This rate environment had been dissipating for a while, but finally ended in the 2008 financial crisis.
In the UK post the financial crisis, there was high inflation, but no significant wage inflation. So, effectively, there was a standard of living drop ; things cost more, but peopledidnot have more money to spend. Such a drop in standard of living makes an economy more competitive, and is an alternative to productivity improvements in keeping businesses competitive in the global marketplace. In the UK, adjusting for population growth, disposable income per head returned to pre-crisis level only for 2017. Post the financial crisis (and for the first time) wages are not moving with economic (GDP) growth. The economy grows, but wages do not. Why is this?
Inflation is not the only reason wages increase. In tight labour markets, the supply and demand for labour drives changes in wage levels. In times of high unemployment, there is more labour than jobs, so the price of labour (wages) drops. The reverse should also be true. Some countries currently have seemingly low unemployment. In the UK, there are historically very low levels of unemployment, prompting a question as to why, in such a tight labour market, we have not seen any meaningful wage inflation.
What else supports wage growth in line with inflation– and even wage growth in excess of inflation– without creating more inflation?
The answer is productivity. What do we produce for the time we work? More production per hour means room for more pay per hour. This is the single real driver of sustainable economic growth. What drives productivity is investment (in things that helps us work / produce) and skills (education and training). Deregulation is often cited (lower cost / reduce time), as is connectivity (infrastructure), or having storage and transportation you can easily use. Even being located correctly– such as near someone who buys your products or can distribute them– can play a role.
We have been in a period of significant technological change, so the investment category should have a big tick. And, in the UK, we have seen some infrastructure work. And the single market in Europe provides an easy export / production area. However, productivity post the financial crisis has improved at much slower levels than before the crisis. In the UK, in effect, the overall level of productivity has barely changed in 10 years.
So, we have inflation, employment levels, and productivity changes. None of these factors are moving wages higher. What is happening?
There are a few reasons to think the labour market and corporate environment have changed so as to make low-cost labour a better alternative than investment in improving production. You can keep operating expenditure low enough with these labour markets to negate the need to pursue capital expenditure.
The labour market has changed. There has been a shift in the balance of leverage between workers and employers. In the UK (and US), there has been a long-term decline in unions driven by changes in the law, and a related reduction in the ability of workersto negotiate as one (collective bargaining).
The fall in labour union membership– and the falls in rate of productivityimprovement in the developed world– have followed a related course for decades. As union membership has fallen, so has the level of productivity improvement.
If unions were effective, it is possible that they kept the price of labour high relative to alternatives, so corporates were rewarded for investing (capital expenditure) to improve operational productivity to allow them to produce more with less people (operational expenditure). As unions, and therefore employee leverage, has receded, labour has become consistently cheap versus alternatives. There is less and less reward for capital expenditure that reduces the reliance on labour. You are better off employing cheap labour than investing in automation.
In the UK, two classic examples of this are building construction and farming. Neither has experienced significant or meaningful automation, and both have relied on the labour market with an emphasis on accessing pools of cheaper labour.
Counter to this move to a very flexible labour market, there has been the reverse trend with corporations. There has been a significant trend toward corporate consolidation. This has created much fewer and larger employers. As a result, on the employer side, bargaining power has increased.
We see this in the US, where there is a growing concern that companies are getting larger relative to the geographical area they operate in, so as to become dominant. We refer to this occurrenceas “monopsony.”As a result, the workforce with a particular skill set has fewer choices, orno choices, to switch employers. The labour price is then heavily constrained. Even if someone relocates geographically, they may end up in another area dominated by another single employer in the activity they are employed in.
This change in the bargaining equilibrium between employer and employee has been further perturbed by changes in the legal environment pertaining to employment. Examples include zero hours contracts, and the use of non-competes. In the US, there is currently a legal case pertaining to a non-compete for a building cleaner.This, plus the leverage of technology, has created the gig economy –the new technology-managed casual economy.
In this context, it is slightly ironic that, in the UK, one of the most visible technology-driven changes to a product manifests itself as a mass of very low-paid workers driving mopeds to deliver food. To the above points, this will be even more on trend if the company is bought by a mega tech corporate, especially one that specialises in leveraging the gig economy.
Two things emerge here. Maybe the labour market is not as tight as it looks. Adjusting measures of employment to capture the true slack in the economy may show a labour market that has plenty of idle or underused capacity. Official unemployment may register as low, but there is a large pool of people who are not unemployed, but are not fully engaged in the labour market either. And, even if it did tighten, the price dynamics wouldnot pressure higher wages until much tighter labour markets emergedthan were historically needed to raise the cost of labour. This explains why the Phillips curve model seems not to be working as expected.
Other drivers are also at work on wages. Globalisation has significantly increased the pool of low-paid workers available. Migration brings new workers into labour pools, where these new workers will accept lower wages.Other factors also impact wage growth dynamics. Changing demographics, education, and the trends in private versus public sector employment levels are just some examples.
What does that mean for the future? In the UK, labour’s share of national income is on the decline. More of the national income goes to the owners of land and financial assets. Labour is getting cheaper on a relative basis.
In the short term, we may see some pickup in wage inflation. In the UK, average earnings have picked up recently, and have grown in excess of inflation. So, late in an economic cycle, this is quite possibly a very short-term factor and, effectively, an anomaly. Certainly, longer-term, the factors described here speak to a continued stagnation in the cost of labour in the developed world.
Does that mean interest rates will not rise in the developed world? Certainly, it is one factor supporting rates not rising quickly, and not returning to levels higher than the long-term average. We may see late economic cycle wage pressures, but only at the end, and only for a short period.
So, why do rates rise at all? Even without inflation, rates were exceptionally low coming out of the 2008 crisis, and tightening them to normalise them to some extent prevents excesses and, therefore,makes sense. These excesses, though, are unlikely to be in average wages. More likely, they are needed to reprice credit to manage debt accumulation that has resulted from very low interest rates. Rising rates will bump into a debt mountain before they are everpushed higher by wage inflation.
Structurally, meaningful wage inflation may now be a thing of the past.