The UK labour market looked to be steadying in the first few months of the year, albeit at a weak level. The unemployment rate dipped and pay growth reached target-consistent levels in February. However, energy prices have surged since then, which means the unemployment rate will tick up in the coming months as firms grapple with even higher costs, including National Minimum Wage changes. Indeed, we now expect the unemployment rate to peak at 5.5% later this year. A softening jobs market does lower the risk of second-round effects from stronger wage growth. This is a key reason why the Bank of England will almost certainly keep interest rates on hold next week − and probably throughout this year.

February’s UK unemployment rate fall masks weakness

The big positive in the latest data was the unemployment rate falling to 4.9% in February from January’s 5.2%. Even if much of this decline unwinds in March, unemployment will still probably undershoot the MPC’s forecast of 5.2% for Q1.

However, February’s fall was mainly driven by people dropping out of the labour force, rather than a genuine improvement. In fact, employment rose by just 24,000 in the three months to February, which is well below population growth.

Payrolled employment for February was also revised down from a gain of 20,000 to a loss of 6,000 jobs. This suggests a more subdued jobs market in February than the headline unemployment rate suggests. What’s more, the early data for March supports this view. Here, payrolls fell by 11,000 and vacancies by a similar amount. Payrolled employment within the retail sector in March also hit its lowest level since records began.

As our new Workforce 2026 survey shows, rising employment costs and the Employment Rights Act mean employers are already rethinking their recruitment and people strategies. Looking ahead, the risk is clearly that higher energy prices will push up firms’ input costs while the hit to real household incomes means consumers will pull back on spending. This will prompt firms to reduce hiring activity. It’s why we now expect the unemployment rate to peak at around 5.5% this year, despite signs as 2026 got underway that the labour market was levelling out.

Subdued wage growth lowers UK rate rise risk

Private sector pay excluding bonuses − the measure most relevant to the Monetary Policy Committee (MPC) as it’s more reflective of underlying inflationary pressures − dropped to 3.2% from 3.3%. . This means it should come in comfortably below the MPC’s projection of 3.5% in Q1.

Workers have less bargaining power now than they did in the last energy crisis in 2022 because the labour market was much tighter then. So, workers will struggle to bid up nominal wages to protect their real incomes. We expect pay growth to stabilise around 3.25−3.5% this year, with inflation likely to peak at 3.5−4%.

This picture of a softer labour market and more contained wage bargaining substantially lowers the risk of higher energy prices feeding through into second-round effects, which is what the MPC is most worried about. That means our base case is still for the MPC to keep rates on hold this year to avoid weakening the labour market further, particularly as energy prices have fallen back from recent highs, suggesting a smaller rise in inflation.

Admittedly, if there’s no permanent solution to the conflict in Iran soon, then we expect energy prices to surge again. This would push inflation much higher and strengthen the case for rate hikes. Either way, we expect any tightening cycle to be relatively short as the MPC’s focus would quickly switch back towards the UK’s subdued underlying economic growth and the weak jobs market.

Ultimately, the labour market was stabilising at the start of the year before the conflict in Iran dampened the outlook. However, it’s likely to weaken further over 2026 as higher energy prices cascade through the UK economy. This will temper the need for the MPC to aggressively raise interest rates, with Members opting instead to keep rates hold this year before resuming rate cuts in 2027.

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