Minimum wage rise will offset hit from inflation, but not much else

The upcoming rise in the national living wage will put some further upward pressure on firms’ costs over the next year and, combined with labour shortages, could feed into concerns about rapid wage growth pushing up inflation. 

The middle market firms that comprise the real economy are adapting to the tighter labour market by either paying higher wages, improving working conditions, or offering workers more flexibility –sometimes all of the above.

At the same time, many businesses are looking to offset soaring costs by substituting technology for labour. But this dynamic will remain fluid as the natural tension between labour and capital evolves.

In the end, the outlook for increases in real pay and the associated rise in living standards will depend on the UK improving its dire productivity growth.

Nominal pay rising but real pay still flat

The Chancellor announced over the weekend that the national living wage, which applies to people over 22, will rise by 6.6% from £8.91 per hour to £9.50 per hour in April 2022. What’s more, the national minimum wage, which applies to 21-22 year olds rose by 9.8%. It seems likely that the age threshold for the national living wage will be lowered to 20 next year, giving a boost to the earnings of younger workers.

The minimum wage in the UK has done a remarkably good job of keeping pace with, and even exceeding, growth in average earnings. Indeed, in 2000 the minimum wage was worth 38% of average hourly earnings and by 2021 that had risen to 48%. (Contrast this to the situation in the United States, where the federal minimum wage has fallen from 50% of the average wage in 1964 to 28% in 2021.)

The Chancellor has also announced that the public sector pay freeze will end, so there are likely to be substantial increases in public sector pay growth as well.

Given that inflation is likely to be around 5% by April 2022, however, most of the increase in the minimum wage and public sector pay will be offset by higher prices, meaning that real income growth will be subdued. Real household disposable incomes will probably be kept flat over the next year by tax rises and lower universal credit payments.

Low real wage growth has been an issue in the UK for at least a decade. The key to sustained real wage growth is higher productivity–without it, higher nominal earnings will eventually be offset by higher inflation. As workers produce more, firms can afford to pay them more. However, productivity growth in the UK has been woeful ever since the Great Financial Crisis of 2008. Over the last ten years, output per worker grew by just 0.7% per year. This means that the scope for real wage increases has been limited.

What can businesses and consumers expect?

It’s no surprise that consumers are going to be handed at least part of the bill for higher operating costs linked to the increased minimum wage rate. After all, there won’t be a sudden jump in productivity in April, and labour shortages mean that pay increases for low-wage occupations are likely to keep up with the inflation rate.

There are about 2 million people on the minimum wage, or about 7% of all UK workers. Minimum wage jobs are especially prevalent in Northern Ireland, the Midlands and the North East, where about 10% of jobs are paid at or below the minimum wage. Low-paid employees tend to be part-time, younger, in elementary occupations and in the accommodation and food services industry.

It’s hard to argue that paying low-income working families more would damage the economy. Payments to low-wage families – either through increased wages or public assistance—are spent in their entirety on food, shelter and other necessities, and that consumption is added to the sum of economic output.

Think of it this way: While the cost of a Big Mac might have to go up and your tab at your local restaurant might increase to account for the higher cost of paying the server, the cost to society of maintaining adequate living standards for low-wage earners through public assistance payments, such as universal credit, should diminish.

Policy takeaway

The Monetary Policy Committee (MPC) will be laser-focused on wage growth over the next year. Increases in the minimum wage will only heighten concerns that faster wage growth will keep inflation above target for longer than the MPC is comfortable with.

However, inflation will fall sharply in the second half of next year as the recent surge in energy prices starts to fade out of the annual comparison. And even though inflation expectations have been creeping up, they remain well anchored. In our opinion there is very little chance of higher wages feeding an inflation spiral that keeps inflation above the MPC’s target in 2023.