Wage inflation is now rising. Latest figures show that nominal pay rose by 3.3 per cent in the year to October, the fastest increase since 2008. This acceleration in pay, however, might not last.
This seems a strange thing to say when the unemployment rate is near a 44-year low. Although this rate is an imperfect measure of the tightness of the labour market – there are a further 1.9m people out of the labour market who want a job, and many more in work who would like more hours – it surely suggests that the forces of supply and demand are moving in favour of higher wage growth.
They are. But there is a less obvious but nevertheless important reason why wage growth might not rise much.
To see it, consider what determines pay in the long run. Just two things matter most. One is the level of prices: wages must in the long run keep pace with these. The other is productivity: the more we produce, the more we can pay ourselves. This year, pay growth has exceeded both of these. Since the fourth quarter of 2017, wages have risen 3.5 per cent but consumer prices have risen only 2 per cent and productivity has fallen.
Because of this, wages are now slightly higher than they should be, given their historic relationship with prices and productivity. Historically, when this has happened, they have subsequently fallen back. To put it in econojargon, there’s cointegration and an error correction mechanism between wages, prices and productivity. For this reason, economists expect wage growth to fall back next year: the median forecast of private sector economists is for earnings growth of 2.9 per cent next year.
This, of course, means yet another year of very little growth in real wages; in fact, wages now are still 5 per cent below their 2007 peak. The biggest reason for this is not that employers are exploiting their workers more: Bank of England economists estimate that employers’ power in labour markets hasn’t changed much since the late 1990s. Instead, it is that productivity has been so weak. With aggregate hours worked having risen recently, such weakness looks like continuing.
You might think a fall back in wage growth will be good for profits, as it reduces the threat of rising costs.
Not necessarily. Wages are not just a cost. They are also a source of revenues: if we’re not earning more we cannot spend very much more. There’s a direct link between the decade-long squeeze on real wages and the closure of pubs and retailers. Weak growth in real wages threatens to continue this trend.
In fact, it might even get worse. Spending has held up in recent years because households have dipped into their savings in an effort to maintain consumption in the face of falling real wages. But this cannot continue forever. With the savings ratio close to its lowest level since the late 1950s it could rise soon: another cointegrating relationship is that between incomes and spending. If consumer spending grows more slowly than wages, then profits will be squeezed.
There’s no relief for investors in low wage growth, therefore. Stagnant productivity – the main cause of weak real wages – is bad for us all.
