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OPINION

The year of the pay rise?

The year of the pay rise?
December 9, 2014
The year of the pay rise?

The reason for thinking they will do is very simple. It’s the Phillips curve. This says that lower unemployment should lead to higher wage inflation. With unemployment having fallen by almost 600,000 since its peak in 2011, this points to increasing wage inflation.

But there’s a problem here. A simple plot of nominal wage inflation against the unemployment rate 12 months previously since 2000 does not show a curve. Instead, it shows two clusters of points: a combination of unemployment around five per cent and wage growth between two and six per cent before the crisis; and unemployment of 7 to 9 per cent since with wage inflation under three per cent since 2008. Within these clusters, there’s no clear negative relationship between wage inflation and unemployment. For example, wage inflation is lower now than it was in 2012, even though unemployment is lower.

The statistical basis for expecting higher wage growth isn’t, therefore, as strong as common sense suggests. This should alert us to the fact that there are reasons to suspect that wage inflation won’t rise very much.

One of these reasons – which the Bank of England’s monetary policy committee has discussed – is that low price inflation can lead to low inflation expectations. These could in turn hold wage growth down simply because if employers don’t expect to raise prices, they’ll not raise wages either. And if workers expect prices to stay low, they’ll not demand big pay rises.

That’s a reason to expect low nominal wage growth. There are also three reasons to expect low real wage growth:

- The public sector will be holding down pay and shedding staff: the OBR foresees government employment falling by 100,000 (1.9 per cent) in the next 12 months and by almost million by 2019-20. Although many economists doubt that such big cuts will happen, to the extent that they do there will be a supply of labour to the private sector which will help hold down wages there.

- As the recovery continues, mismatches between some of the unemployed and vacancies should diminish, as workers retrain or move to where there are jobs, or as employers lower their standards. This could alleviate localized labour shortages and hence wage pressures.

- The labour market has become more globalized. Economic theory – in the form of the factor price equalization theorem – tells us that international trade should lead to an equalization of wage rates around the world. Given that the UK is a high-wage economy relative to China and India, this implies downward pressures on wages. And immigration might, in the short-run, also hold down wage growth.

The key phrase in that last sentence is “in the short run”. Low wage growth in the short-term is quite consistent with decent long-term growth. If real wage growth stays low, the Bank will keep interest rates low and companies will continue to hire in the confidence that costs won’t increase. That could help prolong the expansion.

Perhaps the best available prospect for British workers is that they’ll get rich slow. Whether this is good enough is a question which equity investors should hope is not asked.