Boom time for wages? How realistic is a doubling of wage growth by the end of the year

Last week’s Bank of England Inflation Report raised the prospect of a boom time for wages in the coming year. By the end of 2015, the Monetary Policy Committee (MPC) projects that average weekly earnings will be growing at an annual rate of 3½ per cent, up from a forecast of 3¼ per cent back in November. This increase is set to come about alongside a simultaneous slashing of inflation expectations from 1.4 per cent in the November report to just 0.5 per cent in the latest figures. As a result, the previous real-wage growth projection of 1.8 per cent has jumped to 3 per cent: well above the pre-crisis norm and faster even than the ‘good time’ years of the late 1990s.

Today’s inflation figures – showing a fall in CPI to just 0.3 per cent in January 2015 – suggest that one part of the equation at least is on track. But what about wages: is it realistic to assume that nominal pay growth will almost double in just 12 months even as inflation undershoots its target so spectacularly?

The case for optimism rests on the hope that a virtuous cycle will develop in which rising disposable incomes and increased confidence helps boost private sector spending and investment, even as the next government continues to cut public expenditure. But across a series of key assessments, uncertainty reigns.

At the heart of its nominal wage projection, the MPC points to continued narrowing of slack in the labour market. Yet the evidence in recent months has been mixed. Unemployment has fallen, but employment growth has slowed, with the mismatch accounted for by a small dip in the participation rate. Average hours worked have risen faster than expected, but reported underemployment remains substantial and the Bank has raised its estimate of the equilibrium level of average hours worked (meaning the gap between actual and desired hours is little altered).

Despite this apparent slowdown in labour market tightening since November, the MPC expects wage pressures to build as slack shrinks further in 2015. It acknowledges considerable uncertainty however, and – teasingly – the Inflation Report notes “a wide range of views on the Committee” as to what will happen next.

One of the other factors underpinning the Bank’s 2015 projection is its assumption that ‘compositional factors’ will not drag on pay growth in the same way they did in 2014. The Bank has concluded – chiming with our own decomposition analysis  – that average pay was affected in 2014 by the return to the workforce of significant numbers of younger and less experienced employees. With this employment surge unlikely to be repeated in 2015, the associated drag should drop out of the data.

However, it is less clear whether the same can be said for the rapid growth of lower-skilled roles, which we found to have the single largest negative compositional effect in 2014. If our labour market has entered a new phase in which increasing numbers of lower-skilled jobs are being created, then we might expect this particular compositional drag to persist.

And it’s worth remembering that this negative ‘employment effect’ forms only part of the story. Sluggish nominal pay growth in the first part of 2014 owed far more to a pure ‘wage effect’, whereby earnings simply grew by less than in previous years even after controlling for changes in the make-up of  the workforce.

Recent survey data suggests the continuation of such subdued pay growth within firms. The Bank’s 3½ per cent projection appears highly questionable when set against the CIPD finding that fewer than one in seven firms in its latest survey are explicitly planning pay rises in excess of 3 per cent in the coming 12 months. Overall, fewer than half the firms surveyed are factoring in any form of real-terms pay rise.

Uncertainty prevails, which is hardly new.  Yet it might just matter more than it has over recent years in the current climate. That’s because low and falling inflation raises the prospect that pay deals will dip further in the coming months. Indeed, the Inflation Report reported that reduced inflation expectations was the factor most cited by employers as likely to reduce labour costs in 2015, relative to 2014.

And of course, the lower inflation falls (and the more the ECB’s policy of quantitative easing lowers the value of euro relative to the Pound), the greater the chance that we are headed for a period of deflation – with dampening effects on consumer spending potentially forcing us into a downward economic spiral. Particularly so given the limited room for further monetary loosening open to the Bank of England. Such a scenario remains unlikely, but it must at least be considered a possibility.

Following a six year period in which pay growth outpaced inflation in just five out of 75 months – the longest and deepest pay squeeze since at least the mid-1800s – the prospect of a rebound in pay along the lines set out by the MPC would undoubtedly provide welcome relief for millions of hard-pressed workers. Indeed, we might be forgiven for asking why it’s taken so long for the bounce-back that almost always follows tough times to appear. But this happy scenario continues to rest on a very particular reading of a highly uncertain future. We’ve yet to see any strong signs in the data to suggest that nominal wage growth is on track to double by the end of the year. If that’s to happen we would need to see strong clues appearing sometime soon.