Bank of England Governor Andrew Bailey has been widely criticised for calling for wage restraint. And rightly so: the days when we thought inflation could be cured by asking workers to accept low pay should have ended with flared trousers and kipper ties. But it poses the question: is wage inflation really a cause of higher price inflation? The answer is: no, not now.
In theory, there are two mechanisms through which wage growth might fuel inflation. One is that high wage growth will boost consumer spending, allowing companies to raise prices. But this is not happening now. Retail sales volumes in December were only 2.1 per cent higher than two years’ previously. Granted, sales then were depressed by fears of Covid, but even adjusting for this sales growth has been below its long-term average recently.
Demand, then, isn’t so strong as to generate huge inflation. Consistent with this, inflation is largely confined to a few sectors. Just three items – fuel bills, petrol and second-hand cars – account for 1.9 percentage points of the 5.4 per cent CPI inflation we saw in December.
There’s a simple reason for this. Wage growth is not high. In the three months to November average weekly earnings rose by 4.2 per cent compared to a year ago, and PAYE data show that in the year to December median monthly pay rose 5.3 per cent year-on-year. Both these numbers are below the inflation rate, meaning that real wages are falling. That’s no recipe for an inflationary boom in demand.
Of course, the wage growth we are seeing now reflects decisions made months ago when CPI inflation was low. But more recent wage settlements don’t point to a big increase. According to Incomes Data Research, the median pay settlement is now 3 per cent, up by only one percentage point on 12 months ago.
A second possible mechanism is that simply that rising wages add to companies’ costs which can lead them to raise prices. On their own, however, wages are not the issue. Instead, what matters is wages relative to productivity: a wage rise matched by an efficiency saving or greater output is not inflationary.
We used to have a rule of thumb. Aggregate wage growth of around 4 per cent a year was consistent with inflation being around its 2 per cent target. This was because trend productivity growth was around 2 per cent, so 4 per cent wage growth meant 2 per cent growth in unit wage costs which in turn meant firms could raise prices by 2 per cent and maintain profit margins unless other costs such as of raw materials were rising strongly.
If this rule still held, there would be no alarm about weekly wage growth of 4.2 per cent. But it doesn’t. Productivity growth has slowed since the mid-2000s, which means the nominal wage growth consistent with the inflation target has come down. The pandemic has increased the volatility of productivity, but it’s likely this was only around 2 per cent higher at the end of last year than it was at the end of 2019, consistent with that productivity slowdown. And there’s no reason to suppose the pandemic will eventually raise productivity. Quite the opposite. In cutting business investment and depriving people of experience, it might cut it.
Urging wage restraint thus distracts us from the fundamental problem – that productivity growth is so sluggish.
