Rethinking the Role of Wage Growth in the UK’s Economic Recovery

The Bank of England’s preoccupation with taming wage growth may be misplaced in the current economic landscape. As the UK grapples with inflationary pressures and the cost of living crisis, concerns about a wage-price spiral have driven interest rate hikes. However, a closer look at the situation suggests that there may be more effective approaches to curbing inflation than focusing on wage restraint.

One of the key drivers of the recent surge in inflation was the spike in import prices, fueled by soaring global energy and food costs triggered by the conflict in Ukraine. This resulted in a significant “terms of trade” loss for the UK, dampening national income by around 1.5% at one point last year.

Yet, the tables have turned. The impact of this price surge, which pushed consumer price inflation above 10%, has now reversed. The terms of trade currently stand in a more favorable position than at the beginning of 2022.

Consequently, inflation is rapidly declining, with consumer prices rising annually at a rate below 2% in June and a CPI index that fell by 0.4% in July, primarily due to declining energy prices.

Initial concerns revolved around the UK’s apparent loss of real income due to rising import prices. The worry was that if companies and workers attempted to restore their previous income levels, it could lead to a wage spiral reminiscent of the inflationary woes of the 1970s. However, with the terms of trade making a recovery, this fear seems outdated.

Now, the focus has shifted to the scale of wage increases and the potential for sustained core inflation above the target rate. While these concerns are valid, the bigger picture demands attention. Real wages have declined by 4.5% since the beginning of 2022, failing to keep pace with rising inflation. Meanwhile, corporate profits have surged by approximately five percentage points in their share of national income. Although government subsidies have supported household incomes, tight labour markets indicate that wages should not be expected to fall significantly. Therefore, it’s reasonable to anticipate that average earnings will outpace price increases for some time, a warranted and appropriate scenario.

Attempting to restrain wage growth at this juncture equates to advocating for salary reductions, which is counterproductive in light of the prevailing economic conditions.

It’s important to acknowledge that this dynamic has a sectoral dimension. Industries that marked up prices in response to higher input costs have witnessed increased profit margins. If these sectors maintain prices as costs decline, their profit margins could expand further. While the primary beneficiaries might be concentrated in the energy and food sectors, the impact extends to real wages across all industries. Employers will inevitably face wage demands. If they concede and raise prices, inflation persists unless prices fall in sectors where profit margins have risen. This phenomenon is evident in the energy and, to a lesser extent, food sectors.

The critical policy question now revolves around whether employers will respond to the inevitable above-inflation wage demands by seeking to preserve their previous profit margin gains. This, in turn, depends on the strength of economic demand and activity. The effectiveness of such policies is further complicated by the varying and often lengthy lags in monetary policy. While interest rate hikes have swiftly affected the cost of consumer credit, their impact on mortgages has been delayed due to fixed-rate contracts.

There are tentative signs of a slowdown in economic activity and a slackening labour market. Longer leading indicators, such as money supply, also point in the same direction.

Given these complexities, the Bank of England should reconsider its focus on restraining wage growth and exercise caution when contemplating further restrictions. A more holistic approach that considers the broader economic landscape, including demand, inflation dynamics, and the enduring impact of past policy decisions, is a more effective strategy for navigating the UK’s economic recovery.