Labour market loosening gathers pace, but pay growth worries MPC

A rising unemployment rate, a huge fall in payrolls, a collapse in vacancies and slowing wage growth all point to a rapidly weakening labour market. The latest labour market data, released this week, also suggests weakening caused by higher employer National Insurance Contributions (NICs) didn’t peak in April. Provisional indicators for May point to further and faster labour market easing. Yet, private sector pay growth is still running at almost double the rate the Monetary Policy Committee (MPC) regards is consistent with 2% inflation. We therefore think an interest rate cut next week is off the table. However, the data does support further easing later in the year and two more cuts to leave interest rates at 3.75%

NICs hike impact deepens in April and May

Briefly, the headline data shows a gradually weakening labour market. Employment is trending up, with the official measure of employment rising by 89,000 in the three months to April. But a rising population and a drop in inactivity helped push the unemployment rate higher for the second consecutive month to 4.6%, in line with our expectations at the start of the week.

Moreover, the Labour Force Survey (LFS), remains distorted by a low response rate and makes it difficult to get a full read on what’s happening. The Office for National Statistics (ONS) increased the sample size significantly to improve reliability. However, this is only the second month for the fully adapted data.

For now, we must look at a broader set of indicators to get the full picture, which shows the momentum for labour market loosening gathering pace.

What does payrolls data tell us?

HMRC payrolls data tracks employees paid through pay-as-your-earn (PAYE) where firms compensate above the earnings limit. It points to a much swifter loosening in the labour market than before. The measure dropped by a huge 109,000 in May – the biggest fall since May 2020. We also interpret this data with caution for two reasons: payrolls are often subject to big revisions (we expect one next month) and this data was collected earlier than usual. More concerningly, falls in payrolls are usually revised up. Yet, April’s payroll estimate was revised down by 22,000: to -55,000 instead of -33,000.

Even the 17,000 increase in self-employment in the three months to April can’t explain the dramatic fall in payroll numbers. In some sectors, payroll tax rises have incentivised self-employment models. This may explain part of the deviation between payrolls and LFS data. However, it clearly doesn’t explain all of it.

Adding to this picture of a still-loosening labour market, HMRC payrolls are now trending down at the fastest rate since the pandemic. The picture payrolls data paints now more closely reflects the figures suggested by business surveys and Bank of England’s Decision Maker Panel (DMP) in 2024 and earlier this year.

Lowest-paid and private sectors impacted most

Industries are feeling the impact to different degrees. The lowest-paid sectors continue to be hardest hit. Hospitality payrolls have shrunk almost 4% since the Autumn Budget. The retail sector shed more jobs in May than it had between October and April, suggesting payroll tax hikes continue to bite.

Private sector employment in particular remains in the doldrums. Vacancies are down nearly 17% on last year and payrolls continue to accelerate downwards, even if the May figure overstates the weakness in the jobs market. 

Weak labour demand prompts falling pay growth

So, what’s the real economy impact of this and for the Bank of England and interest rates? There’s some evidence this weakening demand for labour is starting to find its way into slower pay growth as workers find it harder to bargain for big pay rises against a backdrop of a slowing jobs market.

Indeed, regular private sector pay growth, a measure important to the MPC because it is most reflective of underlying inflation pressures, slowed to 5.1% from 5.5%. That’s still far too high to return inflation to 2% sustainably, but it is below the MPCs forecast of 5.2% in Q2 and wage growth now looks set to undershoot that figure.

That said, regular private sector pay gained 0.5% m/m. This was likely driven by April’s chunky 6.7% rise in the National Living Wage (NLW). That probably reflects those one-off hikes more than anything else and growth has materially slowed in the last few months.

We expect pay growth to continue to slow across the rest of the quarter before ending the year around 4%, which should encourage the MPC to continue with gradual cuts.

Labour market data builds case for two more cuts this year

Taking it all together, this latest data clearly suggests that the labour market is easing slightly more quickly than anticipated. All things being equal, this suggests there is room for rate cuts this year to support the jobs market.

However, we think the MPC’s hawks will be too concerned about wage growth and above-target inflation to cut interest rates this month. Bank of England (BoE) Chief Economist, Huw Pill, has already voiced concern that “real income resistance” may have sustained momentum in wage bargaining dynamics, despite the weaker labour market. That implies high pay growth throughout this year and next because inflation won’t return to target until 2027.

The BoE had always thought a margin of slack was needed for wage growth to return to the normal 3% that MPC members emphasised is consistent with 2% inflation. While a margin of slack has started to open, the latest data will strengthen the doves’ case, who will have growing concern that the labour market is loosening too quickly. However, we expect the MPC to hold interest rates next week as they wait for more data on what’s happening in the jobs market following April’s tax rises and tariffs.

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