The latest economic data mostly show a downbeat picture of the UK economy as we move into the new year. GDP is falling and the volume of retail sales is contracting, down more than 6 per cent on a year ago. Most economic forecasters expect the output of the UK economy to drop back this year, although the consensus view is that it will be a mild recession, with GDP falling by less than 1 per cent in 2023.
The most recent indicators from the labour market show a mixed picture. Total employment continues to rise and is nearly 200,000 up on a year ago but the number of hours worked is now declining. The unemployment rate has risen slightly, to 3.7 per cent, but this is still very low by historical standards. Meanwhile, the number of unfilled job vacancies is falling but at more than 1.1 million this still points to a very tight labour market.
Perhaps the most worrying trend in the labour market is the upward trend in wage increases. Even though pay growth has not kept up with inflation, it is now running at nearly 7 per cent per annum in the private sector. Early indications from payroll data for November are that wage inflation is moving up to 8 per cent. There was always a worry that the recent surge in inflation could turn out to be more persistent if pay growth picked up in response to rising prices. This now seems to be happening, in the private sector at least.
One way of interpreting these mixed signals from the labour market is that they are lagging behind the trends in output and spending. If that is the case we could see employment and vacancy rates falling back this year and upward wage pressures easing once inflation starts to fall. The Treasury’s latest survey of economic forecasts shows that the average projection is for inflation to drop to about 5 per cent by the end of this year and wage increases to fall back to 4.5 per cent. The unemployment rate is expected to rise to about 4.5 per cent in 2023. This would be a fairly benign outcome, consistent with a mild recession this year and a return to growth in 2024.
There are quite a few reasons, though, that this might be an overoptimistic view of economic prospects. First, it is based on the assumption that a very modest rise in unemployment will be sufficient to subdue wage increases and squeeze out inflation. On the past two occasions that the UK suffered a serious surge in inflation, in the early 1980s and the late 1980s/early 1990s, much higher unemployment appeared to be needed to bring inflation under control. In both episodes the UK unemployment rate rose above 10 per cent.
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It can be argued that we now have a more flexible labour market, which should reduce the unemployment cost of curbing inflation, but the present wave of price and wage increases is the first big test of the more flexible UK labour market that came about as a result of reforms in the 1980s and 1990s.
A second key issue is the impact of structural changes that have contributed to the tightness of the UK labour market. The number of people aged 16 to 64 who are “economically inactive” — not working or looking for work — is now more than half a million higher than before the pandemic. Various explanations have been put forward for this reduction in the supply of labour, including the impact of Brexit on the availability of immigrant workers, long-term health problems caused directly or indirectly by the pandemic and a wave of early retirement. Probably all three of these factors have played a part.
This significant reduction in the supply of labour has contributed to the high rate of vacancies and wage pressures we are seeing but it also means that a much bigger than normal reduction in the demand for labour could be needed to restore balance in the labour market, ease skill shortages and reverse the upward trend in pay increases.
A third challenge to the forecasting consensus for inflation and unemployment would be stronger momentum in upward pay pressures. There are a number of reasons that this might be the case. One is the possibility that expectations of inflation are being pushed up by the wave of price rises, undermining confidence in the Bank of England’s ability to bring inflation back to its 2 per cent target.
Another worrying sign is the increased willingness of workers to take strike action in pursuit of higher pay increases, which has echoes of the industrial unrest of the 1970s. This could be a further indicator that a more sustained rise in wage growth is in prospect, prompting a more aggressive interest rate response from the Bank of England.
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What policies might the government pursue to try to ease the pressure in the labour market? Public sector pay is not the main issue, with public sector wages up only 2.7 per cent on a year ago, compared with 6.9 per cent in the private sector. So holding down public sector pay settlements is simply fuelling industrial unrest and a perception of unfair treatment of public sector workers. A more effective policy would be to seek to boost the supply of labour to ease skill shortages and reduce upward wage pressure, for example by enhancing training and retraining programmes as well as providing targeted support so that people with long-term health conditions can get back to work.
How the UK labour market performs this year holds the key to our economic prospects for 2023 and 2024. If pay growth continues at the present high levels, or rises further, we will not have the benign scenario of a mild recession followed by a swift recovery. The Bank of England would then face a more prolonged battle with inflation, requiring further significant interest rate rises. That prospect is not an attractive economic backdrop for the government as we move towards the next general election.
