The British labour market: A new normal

Widespread labour shortages are seriously limiting business’s ability to recover from the pandemic. Although these shortages are expected to ease this year, longer term the labour market looks set to stay tighter than before the pandemic.

To return to pre-pandemic levels of productivity, firms should invest in automation and upskilling their workforce.

A remarkable recovery

There are now labour shortages across large swathes of the economy – about 600,000 fewer people are in employment than before the outbreak of coronavirus.

However, the UK’s labour market has staged a remarkable recovery over the past year. Despite the largest fall in GDP on record, unemployment peaked at just 5.2% in December 2020. By November 2021 it had returned to 4.1%, only marginally above the pre-pandemic level of 4%.

With that in mind, it’s not surprising that The Real Economy’s most recent survey of middle market business leaders found that over 40% of middle market businesses had trouble retaining and recruiting staff.

Where have all the workers gone?

There are three reasons why employment is lower than before the pandemic:

1. Higher unemployment

There are around 20,000 more unemployed people now than there were before the pandemic. This is a relatively small rise given the magnitude of the drop in GDP. But what’s more concerning is the proportion of unemployed people who have been out of work for more than 12 months. This is used as a benchmark for when an employee’s skill set starts to decline. Before the pandemic it was at 22.4%. It has now jumped to 30.6%.

The level of unemployment is still expected to fall below its pre-pandemic level this year. But workers who have been out of the labour force for over a year should think about getting additional training.

2. Shrinking population

Since February 2020, the working age population (those aged between 15 and 64) has shrunk by 100,000. This is largely due to a sharp drop in net migration: The number of people born in the EU and working in the UK has fallen by almost 140,000 since the start of the pandemic, not helped by coronavirus-imposed travel restrictions.

As the UK enters the ‘living with it’ stage of the pandemic some migration should resume, providing a small boost to the UK’s working population. But, restrictions or not, Brexit’s stricter immigration regime will permanently reduce growth in the UK workforce. Migration flows will never return to their pre-pandemic levels.

3. Inactivity

The biggest reason for the drop in employment is an increase of more than 400,000 in the number of ‘inactive’ people, ie people of working age who are not looking for work.

Of these 400,000, about half are either temporarily off sick or on long-term sick leave (a post-covid rise of about 200,000). The rest is largely made up of students. A portion of those people on long-term sick leave might not return to the workforce, but many will. The increase in student numbers is likely to be reversed now, as the red-hot job market discourages people from taking additional study time.

Employment is expected to reach pre-pandemic levels by the end of this year. Eventually, labour shortages are going to ease. Migration will pick up slightly, students will be able to return to university towns and take up jobs, and the number of people on sick leave will fall. Even so, the UK workforce’s growth over the next decade will be much slower than it would have been without permanently lower migration and an increase in long-term sick leave.

The key thing for middle market businesses to know is that labour shortages are likely to remain a feature of the UK economy for the next few years and that is going to be our ‘new normal’. The slight easing we’ll see over the rest of the year is not a sign that things are getting back to what normal looked like before March 2020. Conditions have changed too much for that to happen.

Power shifting from employers to employees

Power is shifting from management to labour, in part because of a tight labour market and the growing role of technology in the production of goods and the provision of services.

On top of workforce shortages, there has been a fundamental change in the structure of the labour market that salary compensation alone cannot explain. While improved wages go some way to addressing labour shortages, they’re only one part of the solution.

Higher wages are necessary…

The labour market is likely to see a stronger wage growth over the next two years compared to before the pandemic, driven largely by the reduced size of the workforce pool. We anticipate wage growth to average around 4.5% in 2022. Pre-pandemic it averaged just under 3% year over year (y/y).

However, unless this wage growth is accompanied by an increase in labour productivity, firms will be forced to do one of two things:

1. Absorb higher wage costs by shrinking their profit margins, which can reduce investment and impact future growth; or
2. Pass higher wage costs on to their customers, raising inflation and reducing their overall competitiveness.

Middle market businesses should aim to maximise the productivity of their current workforce by investing in automation and training for their existing workforce.

The good news is that the middle market is responding. More than half of our surveyed middle market business leaders said they were investing in new training for existing employees, and 50% said they were investing in automation.

A dramatic increase in UK labour productivity is the only way to ensure that real wages, which take inflation into account, can rise over the long term.

… but not sufficient

It’s easy to see why employee bargaining power in a tight labour market is much stronger than it would be otherwise. But there has been a fundamental change in working preferences coming from the supply side of the labour market.

More workers are looking for better working environments, whether that’s the ability to work from home, flexible work schedules, or preferring employers that prioritise environmental, social and governance (ESG) initiatives. Taken altogether, it’s clear that employers need to offer prospective employees something more than just increased wages and a decent coffee machine in the break room.

The ability to work from home for at least part of the week has transformed the employment landscape. Freed from the requirement of a daily commute, workers and firms can broaden their geographic searches for each other. Long term, this should improve the efficiency of the labour market and lead to improvements in productivity and pay.

The upshot

The solution to the labour shortage is to turn it into an opportunity. Instead of paying the high costs associated with the traditional employment model, firms should think strategically about their hiring plans. Firms need to look at how a prospective employee will complement the advances toward automation and the adoption of new technology.

A business that increases its investment in automation and productivity-enhancing technology, and adheres to ESG standards, will be in a strong position to weather future workforce challenges.