Generations of economics students have been brought up on the concept of the non-accelerating inflation rate of unemployment (Nairu) – the idea that if unemployment drops below a particular level, wage and price inflation will accelerate. From this perspective, next week’s labour market data will look very odd. They are likely to show that wage inflation has levelled off, at 3.5 per cent, even though the unemployment rate is a mere 3.8 per cent, its lowest rate for 45 years. And consumer price index inflation, at 1.9 per cent, has actually fallen a lot since unemployment peaked in 2011.
So, what’s happening?
One thing is that students have been misinformed. In an open economy there is not a single definite Nairu. If the exchange rate rises (as it has since the autumn) or if overseas inflation falls, a country with a tight labour market can enjoy low inflation simply by importing cheap goods. Importing goods is a way of importing labour, thereby overcoming any constraints imposed by a tight labour market.
Also, the UK’s labour market isn’t as tight as the headline unemployment number suggests. In addition to the 1.3m officially unemployed there are almost a million people working part-time because they cannot get a full-time job and another 1.8m who are out of the workforce but want to work: labour market flows data show that a large proportion of these do in fact get jobs. On a wider definition, there are 4.1m people who are jobless. That’s almost one-in-10 of the working-age population.
There is, though, something else – something rather more unpleasant. It’s simply that productivity is not growing, which means it is difficult for wages to rise much.
Over the long-run, real wages must grow at the same rate as labour productivity; we can only pay ourselves more if we produce more. During last year, however, real wages rose faster than productivity – by 1.5 per cent on the Office for National Statistics' definition while GDP per hour worked fell 0.1 per cent. This can only imply one of three things.
One possibility is that labour productivity will rise to validate this rise in real wages. There is, however, no sign of this happening: next week’s figures are likely to show that it actually fell in the first quarter.
A second possibility is that companies will accept the squeeze on their profit margins. This is doubtful. Rising wages were tolerable when raw materials prices were falling last year. But companies won’t find them so acceptable now that these prices are rising again.
Which leaves a third possibility – that real wage growth will fall back as companies try to protect profit margins. One of the ways in which this could happen is that price inflation will rise slightly more than wage inflation over the next few months. History warns us that real wage growth does indeed tend to fall back after it has outstripped productivity growth.
My suspicion, therefore, is that real wage growth won’t rise very much this year, and nor will nominal wage growth.
For investors, this is not great news. For one thing, it means interest rates won’t rise very much, so savers face negative real returns on their cash. And, for another, if we’re not earning very much more we’ll not spend much more. The strength we’ve seen in retail sales so far this year cannot therefore last for much longer.
