What’s holding back nominal wage growth?

Today’s statistics mark another welcome step along the road in our long-overdue earnings recovery. A gentle improvement in regular pay in the three months to February 2015 (now 1.8 per cent, with the total pay measure that includes bonuses close by at 1.7 per cent), against a backdrop of inflation having fallen to 0 per cent, means that real wages strengthened in early 2015.

But how quick will our progress be? Inflation can’t help us along much more than it already has done, and nor would we want it to given the potential risks associated with deflation setting in. Therefore our hopes rest on the continued strengthening of nominal wages which, although gaining ground, remain a long way from their pre-downturn average of around 4 per cent.

The Bank of England is optimistic. In its last Inflation Report it projected that total pay growth will rise to 3½ per cent by the end of this year. We have set out some causes for uncertainty in the Bank’s forecast. Chief among these was a big question mark over the impact of the changing make-up of the workforce. That’s because the official average weekly earnings measure is affected not just by pay changes for employees, but also by changes in the types of jobs and workers in our economy. Previous Resolution Foundation analysis showed these ‘compositional’ changes caused a drag on wages in the first half of 2014. We’ve now updated our analysis to cover the whole of 2014. What clues does this offer in terms of speedy improvements to nominal pay this year?

To recap: our compositional analysis looks across a number of job and employee characteristics in order to understand how much of pay growth is down to changes within groups, and how much is owing to a shift in the proportion of employees across groups. For example, others have highlighted how job creation in lower-paying sectors may have dragged down average weekly pay across all employees since the recession. On the other hand, strong full-time employment growth over the past year will have had the opposite effect. Our approach disentangles the pushes and pulls and takes all factors together, controlling for the overlap between each, to understand how the changing make-up of the workforce is driving wages.

As the figure below shows, the compositional effect is usually positive – you’d expect this given long-run improvements in qualification levels – but it turned negative in the second quarter of 2014 and endured for the rest of the year. Crucially, this compositional drag turned what would have been real (CPI-adjusted) pay growth of 0.9 per cent in 2014 into the fall of 0.2 per cent fall we experienced.

To understand how compositional changes might affect nominal pay growth this year, it’s important to consider what’s driving the drag. The figure below shows the factors pushing and pulling in each quarter.

The return of younger and less experienced employees associated with the employment surge in early 2014 – shown on the figure by the negative contributions of age and tenure – was, of course, welcome. But it created a compositional drag in the first half of 2014 because such workers are typically lower paid than average. As this employment surge has slowed, so we might expect this particular compositional effect to diminish – and there’s certainly evidence of just such a shift in the second half of 2014. It may well drop out of the data altogether in 2015.

In contrast though, the larger, and more worrying, occupational drag – which reflects a continued shift towards lower-skilled roles – became more important through 2014, particularly in the final quarter. Our concern is that rather than reflecting the temporary ‘growing pains’ of employment recovery, these occupational changes may signal a more permanent phase in which job creation is focused at the lower end of the labour market.

The continuing overall compositional drag – and the growing importance of occupational changes within this – put our hopes for a nominal pay surge over the course of 2015 on somewhat shakier ground. When thinking about our progress along the road to wage recovery, a key question is which jobs will grow in the coming months and years and how this might drive, or hold back, average pay.

Of course, there’s a good chance that even with the occupational drag enduring there may be some relative improvement in the overall compositional position compared to 2014, and any kind of rebound would help wage growth along. However, there appear to be sufficient reasons to continue to question the Bank’s optimism in terms of the pace of improvement.

Finally, before we get too fixated on the compositional point, it’s worth remembering that sluggish nominal pay growth during the downturn has owed far more to earnings simply growing by less than in previous years, even after controlling for changes in the make-up of the workforce (shown by the grey bars in the first figure). The pace of our pay recovery therefore rests largely on a pick-up in pay settlements. In this context, it is notable that the Bank has highlighted the potential for today’s ultra-low inflation to weigh down on wage-setting decisions within firms this year. In other words, while inflation staying low might appear to help real pay, any dampening effects on nominal pay could counteract this. A full-blown downward deflationary spiral remains unlikely, but it highlights why we and others are placing such emphasis – and hope – on strengthening nominal wages in 2015.