The labour market and pay

3.1 Labour market tightness

During the financial crisis, output fell and unemployment rose, as companies reduced hiring and increased redundancies. The number of additional hours people wanted to work also rose, perhaps in response to a squeeze in their real incomes. Taken together, these factors led to a substantial degree of spare capacity opening up in the labour market over this period. This, in turn, was a significant factor behind subdued wage growth during 2009–15 (Section 3.2).

That spare capacity has now largely been absorbed and the MPC judges that very limited slack remains (Section 5). Relative to expectations at the time of the May Report, there has been little news in labour market quantities. The participation rate and employment rate were slightly higher, and average hours slightly lower, than expected. The unemployment rate was 4.2% in the three months to May (Chart 3.1). This was broadly in line with the MPC’s judgement of the equilibrium rate of unemployment of 4¼%¹, suggesting little scope for unemployment to fall further without generating excess wage pressure.

Broader measures also suggest that there is limited spare capacity in the labour market. In aggregate, the total net additional hours that people report wanting to work, over and above the hours they usually work each week, has fallen to around zero. As discussed in previous Reports, the proportion of the population who report that they would like a job but are not currently seeking one — the marginal attachment ratio — has fallen sharply in recent years (Table 3.A), suggesting that there is no significant spare capacity among those not actively looking for a job. The number of vacancies per person in the labour force — which is an indicator of the difficulty with which employers would be able to fill jobs — is above its pre-crisis average. The rate at which those already in employment are switching to new jobs has risen to close to pre-crisis rates, although it softened in Q1 (Chart 3.2). And survey measures of firms’ recruitment difficulties are at or above pre-crisis levels.

With little slack in the labour market, growth in the size of the workforce will come mainly from population growth. The MPC’s forecasts assume that the population evolves in line with the ONS’s latest principal population projection, published in October 2017. A key influence on population growth is net migration to the UK. In the year to December 2017, net inward migration rose to 282,000, slightly above the ONS projection. Within this, net migration from the EU has slowed since 2016 H1. The ONS projects net inward migration to fall somewhat in coming years (Chart 3.3), reducing population growth slightly.

The labour market is expected to tighten further in the near term. Employment has continued to grow solidly (Table 3.A) and labour demand growth appears robust. The strength of employment growth over the past few years has been associated with lower flows out of employment rather than higher flows into it (Chart 3.2). Within this, the redundancy rate is around half its pre-crisis average. Many survey indicators of employment intentions remain above their past averages and the number of vacancies remains high. As a result, the unemployment rate is projected to fall to 4.0% in 2018 Q3 (Chart 3.1), broadly as anticipated at the time of the May Report (Table 3.B).

3.2 Developments in pay growth

A tightening labour market and lower unemployment is typically associated with higher pay growth (Chart 3.4) as it becomes more difficult for firms to recruit and retain staff. Whole-economy regular average weekly earnings (AWE) growth — which excludes bonuses — rose to 2.7% in the three months to May from 2.0% a year earlier, broadly as anticipated.

Wage growth remains subdued relative to its past average, though much of that weakness is likely to reflect lower productivity growth than in the past. Labour productivity — the amount of output produced per worker — is a significant influence on the amount of revenue that companies generate, and therefore what they can afford to pay their employees. Therefore, while wage and productivity growth can deviate in the short run, they have tended to move together over time. Productivity fell during the financial crisis and its growth has remained subdued since then (Chart 3.5), particularly relative to its pre-crisis trend. Four-quarter growth in output per head is expected to have remained weak in 2018 Q2. Average hours worked tend to be volatile from one quarter to another, which in turn increases the volatility in output per hour relative to output per head. Indeed, a sharp fall in average hours worked since 2017 H1 has led to a divergence between these two measures of productivity growth.

Because productivity growth tends eventually to be fully reflected in wage growth, slower productivity growth can probably account for around half of the shortfall in average wage growth since 2010, relative to its pre-crisis average (Chart 3.6). Productivity growth is projected to pick up a little, reaching around 1¼% by 2019 — which will support some rise in wage growth — but it is expected to remain below its past average rate (Section 5).

The remaining weakness in wage growth is likely to be mainly due to labour market slack. During much of 2008–17, the unemployment rate was higher than the MPC’s judgement of the equilibrium rate of unemployment. While labour market slack has now largely been absorbed, it can take time for that to be fully reflected in wage growth.

Data from the Annual Survey of Hours and Earnings suggest that pay rises for those switching jobs had increased to pre-crisis rates, both for those moving to a new employer and for those moving to a new role with the same employer (Chart 3.7). Pay rises for those staying in the same job had remained subdued, however, and would need to increase to support a broader rise in labour cost pressures. These data are only available with a lag and the most recent relate to April 2017. Since then, AWE growth has risen and so could suggest that pay rises have broadened out. Recent evidence from the Bank’s Agents suggests that recruitment and retention pressures have pushed up pay growth over the past year (see Box 5). Contacts that reported recruitment and retention having become harder over the past 12 months had increased average pay growth by more than those who reported the level of difficulty as unchanged.

3.3 The outlook for pay and labour costs

Annual growth in average wages excluding bonuses of 2.7% in the three months to May 2018 was higher than in 2016, when growth was around 2½%, and higher still than the average of around 1¾% a year during 2010–15. It is projected to remain around 2¾% in the second half of the year, broadly unchanged since the May Report.

Private sector regular pay growth has also strengthened, to a little under 3% in recent months. Other indicators of private sector pay pressures have also risen. Private sector settlements data are consistent with an increase in median pay growth of around 0.5 percentage points relative to a year ago. The Bank’s Agents’ measure of average growth in labour costs has picked up in recent quarters (Chart 3.8). The REC pay survey, which is a measure of the pay growth of new recruits, also implies a strengthening in pay growth.

In the public sector, AWE growth has picked up notably over the past year, although it softened slightly in the three months to May. Excluding bonuses, public sector pay growth has risen from around 1½% to 2¼% — having been somewhat more subdued than private sector pay growth since 2014 (Chart 3.9).

The 1% cap on public sector pay awards has been lifted from the 2018/19 pay round, which should contribute further to public sector pay growth. The MPC’s forecasts are conditioned on Office for Budget Responsibility (OBR) projections for public sector pay growth, which allow for the lifting of the 1% pay cap². Since the OBR forecast was published, a number of public sector pay agreements for 2018/19 have been announced, as well as a multi-year agreement for the NHS, which could boost public sector pay slightly further. Following the next Budget in the autumn, the MPC’s forecast will incorporate updated OBR projections that include an estimate of the effects of these announcements.

Public sector pay rises will have a direct effect on whole-economy pay growth, as public sector employment constitutes around one sixth of overall employment. There may also be indirect effects, in part as some private sector companies use public sector settlements as a benchmark when negotiating pay agreements, and in part as private sector companies may have to offer higher salaries in response to recruit and retain staff. Empirically, while there is some evidence for a short-term influence of public sector settlements on those in the private sector, there is little empirical evidence for a significant long-term influence.³

Over the next few years, whole-economy pay growth is projected to rise to around 3½% as productivity growth rises slightly and the tightness of the labour market puts upward pressure on wage growth (Section 5).

For inflationary pressures, growth in unit labour costs is more relevant than wage growth alone. This depends on how fast wages and other costs of labour are rising relative to productivity. As explained above, part of the weakness in wage growth in recent years has been driven by weak productivity growth, and as such, unit labour cost (ULC) growth has been less subdued (Chart 3.10).

Non-wage labour costs, such as pension contributions, also affect labour cost growth. These costs boosted ULC growth in 2016–17, in part due to the phased introduction of auto‑enrolment of employees into pension schemes and the abolition of contracting out of the state pension. The minimum employer contribution to pension schemes under auto-enrolment rose in April, and is set to rise further over the next year, contributing a little to overall ULC growth.

Rising wage growth means that ULC growth is projected to average around 2¼% in coming years, a continuation of the gradual acceleration since the crisis. ULC growth averaged ½% during 2010–15 and 1¾% in 2016. Recently, ULC growth has picked up further, although it has been boosted by temporarily weak growth in output per head (Chart 3.10). In part that reflected a temporary dip in output growth in Q1 (Section 2) that was not mirrored in employment growth. As this effect diminishes, ULC growth declines a little from current rates, but remains higher than its average over the past few years, contributing to domestic cost and inflationary pressures (Section 4).

• Notes

  1) For further discussion see Box 4 of the February 2018 Inflation Report.
  2) Economic and Fiscal Outlook, March 2018, Office for Budget Responsibility.
  3) See, for example, Dolton, P, Hantzsche, A and Kara, A (2018), ‘Follow the leader? The interaction between public and private sector wage growth in the UK’, National Institute of Economic and Social Research, mimeo, presented at the Royal Economic Society Annual Conference, March 2018.