The UK labour market is showing clear signs of weakening after a third consecutive rise in the unemployment rate, three years of falling vacancies and another drop in the number of payrolled employees. The picture is not as bleak as it seemed in the spring. Revisions to payrolls suggest the labour market isn’t collapsing at the pace May’s initial 109,000 fall suggested. The numbers were revised up to a drop of 25,000. Private sector pay growth continued to weaken but is still running well above the 3% level that the Monetary Policy Committee (MPC) thinks is consistent with 2% inflation. That said, a weakening labour market and poor growth should allow the MPC to cut interest rates by 25bps at its August meeting despite strong inflation in June.

LFS still distorted by a low response rate

The headline Labour Force Survey (LFS) measure of employment rose by 134,000 in the three months to May, but the unemployment rate still rose for the third consecutive month to 4.7%. A big fall in inactivity and a growing population helped to bolster the size of the workforce as employment continued to grow faster than unemployment.

That said, the LFS continues to be distorted by a low-response rate, despite the Office for National Statistics’ (ONS) best efforts to boost the sample size. The ONS itself believes HMRC payrolls provide a more reliable read on employment.

UK labour market loosens as payrolls fall

HMRC payrolls, which don’t account for the self-employed and off-payroll employment, have painted a much starker view of the labour market in recent months. Granted, reforms to employer NICs have incentivised self-employment, but that only explains some of the story.

Payrolls fell by 41,000 in June’s flash estimate, which clearly shows the labour market continuing to loosen. The good news is that May’s huge 109,000 fall was revised up to a loss of 25,000 jobs. This should ease fears that the labour market was starting to collapse. What’s more, survey data suggests that the pace of job losses should start to ease going forward.

That said, various industries are clearly feeling the pinch of a big rise in employment costs differently. Hospitality and retail payrolls made up over three quarters of the drop in June’s initial estimate and have been responsible for 70% of the fall in payrolls since October. This is unsurprising given that NICs reforms and a big rise in the National Living Wage (NLW) have hit low-paid sectors the hardest.

Turning back to the whole economy, vacancies dropped again in the three months June to 727,000. This represented the 36th consecutive period where vacancies have dropped compared to the previous three months. Falling vacancies continue to support our view that the current loosening primarily reflects firms slowing hiring and choosing not to replace leaving staff rather than a wave of redundancies.

All told, payrolls continue to suggest a quicker loosening in the labour market is underway compared to the LFS, but neither source points to a rapidly collapsing labour market.

Pay growth will undershoot the MPC’s forecast

The MPC will take some comfort from another month of slowing pay growth, which now looks set to undershoot its forecast. Private sector pay excluding bonuses, which is most reflective of underlying price pressures, fell to 4.9% in May from 5.2% and is now comfortably below the MPC’s call for 5.2% in June.

Admittedly, that’s still far too high to return inflation to 2% sustainably, pay growth would need to be closer to 3% for that. However, the evidence suggests that weak labour demand is starting to find it’s way into slower pay growth as employees find it harder to bargain for bigger pay rises against the backdrop of a slowing jobs market.

We expect pay growth will continue to trend down across the rest of the year, where it will finish at around 4%. In the meantime, households will continue to enjoy gains in real incomes, which should help to support a gradual revival consumer spending.

Outlook for MPC – inflation, pay growth and interest rates

Today’s data clearly points to a margin of slack building in the labour market and weakening pay growth. This will encourage the MPC to cut interest rates by a further 25bps in August, supporting the jobs market and a weak economy.

However, we think the most recent data should ease some of the concern on the MPC that the labour market was collapsing. Combined with stronger than anticipated inflation in June, this should dampen some of the more dovish opinions that were starting to form on the MPC that a faster pace of cuts is needed.

Ultimately, we think the latest data continues to paint a picture of a gradually loosening labour market. The MPC will continue to balance a weakening jobs market with elevated inflation as the risks remain two-sided, but this week’s data provides a hawkish tint. Inflation overshot the MPC’s forecasts, and the labour market isn’t collapsing as feared. We continue to expect the MPC to cut interest rates at its next meeting in August before cutting again in November to leave interest rates at 3.75% by the end of the year.

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