14 February 2023
Pay growth in December was still too hot for the Monetary Policy Committee (MPC) to pause its tightening cycle. At 6.7%, earning growth is still double the 3% - 3.5% that the MPC thinks is compatible with 2% inflation. Admittedly, looking under the hood, pay growth isn’t as bad as the headline figures make out. But we think it’s likely that the MPC will judge that it needs to do a little bit more to help bring wage growth down and will raise rates by another 25 basis points (bps) in March.
The good news is that inactivity levels, which are largely responsible for the labour shortages plaguing the economy, dropped sharply in December. If this trend continues it could go a long way to supporting economic growth and reducing wage pressure – the best of both worlds.
Firms putting hiring plans on ice
There are now some reasonably clear signs that demand for labour is starting to weaken.
Vacancies continued to fall, dropping by another 76,000 on the quarter, the seventh consecutive fall. Most surveys of employment intentions suggest that vacancies will fall rapidly over the next few months.
However, at just over one million last month, job openings remain well above their pre-pandemic average. For now, it appears most firms are adjusting to weaker economic activity by putting hiring plans on ice, rather than making redundancies. Employment growth remained strong with an extra 74,000 people becoming employed in December. What’s more, the timelier measure of payrolls jumped by 100,000 in January, indicating that firms are still hiring the workers they can.
In the three months to December the unemployment rate ticked up to 3.7%, from 3.6% in the three months to September, as there were an extra 45,000 unemployed people. The big news, though, was the 113,000 drop in the number of inactive people driven by both declines in early retirement and long-term sickness of 50K and 54K, respectively. That is a big improvement. But labour supply is still materially constrained — down by 280,000 from its pre-pandemic level.
What’s more, there were 843,000 working days lost because of labour disputes in December 2022, which is the highest since November 2011. It will be extremely difficult for economic growth to rebound strongly without getting more people into work.
We expect vacancies to continue to fall sharply over the next year as firms reduce their demand for labour. The recession will also raise unemployment levels but, given the surge in the number of people on long-term sick leave significantly reducing the workforce, the unemployment rate is likely only to rise around 5%, a historically low figure, especially during a recession.
Pay growth far too strong for the comfort of the MPC
The tight labour market means growth in regular pay (excluding bonuses) was 6.7% among employees in the three months to December 2022, up from 6.4% in November. This is the strongest growth in regular pay seen outside of the pandemic period – that is miles above the 3% - 3.5% that’s consistent with the 2% inflation target.
However, its not quite as bad as it looks. Average regular pay growth, which the MPC cares more about, was stable at 7.3% and the single month measure dropped sharply in December, suggesting that momentum is waning. Pay growth has probably peaked now. The slowdown in hiring will lead to less churn in the job market, easing the pressure on businesses to pay more to retain staff. However, the Bank of England will want to see concrete signs of easing wage growth before they consider pausing the tightening cycle. That probably won’t be until Q2 this year as the labour market lags the real economy significantly. As a result, the MPC is likely to hike rates by another 25 bps in March, taking rates to 4.25%, where it will probably press pause.
Given soaring inflation, in real terms over the course of the year, regular pay fell by 2.5%, a near-record drop.
Overall, today’s data suggest that the labour market and pay growth is still too strong for the MPC to press pause on its tightening cycle. But the market has probably passed peak tightness. Pay growth should start to fall and the unemployment rate is likely to start to creep up, especially if inactivity levels continue to fall, meaning the MPC will be able to pause rate hikes after March.