The UK paradox – never have so many worked for so little wage growth…

The UK paradox – never have so many worked for so little wage growth…

by Ewen Stewart
article from Friday 28, July, 2017

ECONOMISTS of a certain age may well remember when the Phillips Curve was all the rage. Some believed back then there was a crude trade-off between inflation and unemployment.  Indeed the current Governor of the Bank of England seemed to suggest he thought this might be the case too, soon after moving into office, when he suggested the Bank might raise the base rate when unemployment fell below six per cent. 

Similarly it was held the lower the unemployment the higher likely wage growth as shortages drove earnings up in times of full employment. Recent experience, however, shows that the relationship between employment growth and wages is weak, to say the least, as strong employment growth in the UK has not fed through to increasing pay packets.

Indeed, the last decade has seen wage growth struggle to keep pace with inflation. On the face of it this would suggest a difficult time for domestic consumer companies however I do not believe the picture is as bleak as it might first appear.

Today, never in the history of Britain, have more people worked either absolutely or relatively. An impressive ,32.6 million are currently in work representing 74.9 per cent of the theoretical workforce which is an increase of almost two million since January 2010. Moreover, the proportion actually in work has increased by 4 per cent over that period while those registered as unemployed are at the lowest percentage rate of the workforce since 1977.

Despite this wage growth has, however, stagnated. While notionally growing at 1.8 per cent, real wage increases  are back to negative territory with CPI currently at 2.6 per cent. Moreover, since 2010 real wage growth has been negative in 5 out of the last 7 years. There are a number of factors behind stagnating salaries some macro, others micro. Firstly, productivity has stalled. The 2 per cent pa forever, which has pretty much been achieved since the start of the Industrial Revolution, has tended towards zero over the last decade. A lack of productivity growth inevitably feeds through to lower wage growth in the longer term.

Secondly, the ruinous state of the public finances has resulted in a price cap on public sector salaries stagnating earnings growth for around a fifth of the workforce. This may continue for a year, or two, more but is clearly under political pressure to abate in the medium term.  This, combined with a squeeze on financial sector total remuneration, has subdued wage growth in two areas of traditionally relatively high pay.

Thirdly, and perhaps most importantly, labour markets moved from being a relatively fixed stock of domestic labour, prior to 1997, (that year was the start of free movement of labour for Eastern EU countries to the UK) to a more fluid one, as the free movement within the EU moved from a trickle to a flow. This, coupled with larger global migration flows, greatly increasing labour supply, thus subduing earnings particularly at the lower end of the employment market.

Despite the likelihood that the UK will leave the Single Market, on a two to five year time horizon (depending on the length of any potential transitional deal), labour flows, over the last 12 months, have continued at roughly the run rate of the last decade at 500-600,000 gross per annum with around 50 per cent coming from the EU and the remainder from the rest of the world. Impending BREXIT has not, so far, impacted flows. Clearly an increase in labour supply, particularly at the lower skilled end of the market, subdues wages.

Fortunately there are now a few factors that could pull wages in a more positive direction going forward.  Firstly the UK minimum wage is very generous by EU standards. It is currently the second highest in the EU and goes some way to explaining the pull factor from many other EU states. By 2019 it will be the highest in the EU if current proposed rises are implemented.

A rapidly rising minimum wage, well above the inflation rate, while potentially damaging employment growth, particularly if there was a downturn, will likely ripple earnings upwards across the spectrum, particularly for those earning 20-30 per cent above the minimum.

Second, while the public finances cannot really justify increasing public sector salaries materially, political pressure could mean that the cap on salary growth is likely to abate in the medium term again adding to wage pressure.

Third, if in the medium term, migration becomes more controlled, and this is quite a big if, the likelihood is wage pressure will resume. This is perhaps the key variable to watch although I do not expect any change in migration flows in the short to medium term.

The last few years have been unusual. The fall out of the financial crisis, open labour markets, public sector pay restraint and weak productivity growth have all handed power to corporates over labour. This has resulted in strong profit growth, for many industries and full employment – but low wage rises.

Global CPI is rising, driven primarily by a rally in commodity prices but also regional factors including recovering Eurozone demand.  For the UK, however, while some of the inflationary trends are the product of global factors, such as a bounce in commodity prices, others are more domestically driven, for example Sterling weakness. While I do not expect Sterling to rally materially against either the USD or Euro, on a twelve month view, given the degree of weakness, particularly against the USD, further significant under-performance is unlikely.

If this is the case the impact of a weaker sterling, on prices, should have worked through the system over the next twelve months.

Globally there are a number of structural factors that should subdue inflation in the longer term. Capital still has the advantage over labour. There remains a global labour surplus with tens, if not hundreds, of millions of agrarian poor still seeking to move into cities. Global productivity gains and new technology should continue to subdue price, including increased internet penetration that has further to run, undermining local pricing and increasing price visibility. That is not to say in localised and specialised industries and services there may be inflationary pressures, but that should be the exception not the norm.

The wild card remains commodity prices. While prices have recovered, from 2016 lows, a material rally from here is unlikely. Further in the short term, the price of oil has marginally abated.

While not formally part of CPI, mortgage and personal loan spreads have also continued to decline, albeit gradually. While I believe borrowing costs are close to a trough I do not believe the Bank of England will raise the base rate in the short or medium term as the economy has become so leveraged on cheap credit and debt to do so would be very damaging to growth.

The cost of debt remains one of the largest swing factors in personal disposable income which I believe the Bank is well aware of and coupled with a debt-funded public sector I see little or no scope to raise rates without materially negatively impacting growth. Post-crash policy continues to create a treadmill that cannot easily be halted without correction.

The bottom line is although current CPI is squeezing incomes, in my judgement inflation should start to abate in 2018 and 2019, moderating pressure on the consumer.

Moreover, while there are signs that the Bank of England is getting increasingly concerned over the rise in unsecured debt, overall household debt has been falling, until very recently, albeit from very elevated levels. While I remain concerned that the UK economy is highly leveraged across the board I suggest that household finances remain robust enough to enable modest further expansion. For good, or ill, any debt expansion is supportive of short-term consumer spending.

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