Stronger pay growth makes May rate hike more likely

The Monetary Policy Committee (MPC) may have all the justification it needs to raise rates again at its next meeting on 5 May. The drop in the unemployment rate to 3.8% in February and the rise in pay growth to 5.4% suggests the labour market is continuing to tighten and, combined with soaring inflation, this could strengthen the MPC’s case for interest rate rises. However, economic growth is likely to slow sharply in the second half of the year and that should give the MPC pause.

The drop of 86,000 in the number of unemployed people dragged the unemployment rate down from 3.9% in January to 3.8% in February. At face value, this suggests the labour market continued to recover in February, although employment rose by only 10,000. Most of the decline in the unemployment rate was driven by a 76,000 rise in the number of ‘inactive’ people (ie those not actively seeking work). This, in turn, was driven by a rise of 48,000 in the number of people taking early retirement, which suggests they have permanently left the workforce. There are now 655,000 fewer available workers than there were in February 2020.

This is especially concerning for the MPC for two reasons. First, the lower unemployment rate implies a tighter labour market, putting upward pressure on wages and inflation. Second, a permanently smaller workforce means the economy can’t produce as much as it could have previously. This will lead to slower GDP growth and higher inflation.

Admittedly, the cost-of-living crisis will result in much softer economic growth from April, and that will lessen demand for labour and ease some of the tightness in the labour market – but we think the smaller pool of available workers will keep the labour market tight for at least the next couple of years.

Real pay will fall further

The tightness in the labour market was reflected in a rise in pay growth from 4.8% in January to 5.4% in February. That is still above its pre-pandemic level of about 3% and will likely make the MPC even more concerned that the recent burst of high inflation is starting to be reflected in wages. Indeed, we expect the MPC to use the strength in pay growth as its main justification for raising interest rates next month.

However, real total pay growth, which takes inflation into account, grew by a much more muted 0.4%. That suggests the cost-of-living crisis was starting to bite in February and will only get worse as inflation jumps in March and April. In fact, if we exclude bonuses then real regular pay dropped by 1% y/y in February. Real wages are likely to fall by around 3% in 2022, which would be the deepest squeeze on spending power on record.

The policy takeaway

The labour market will be central to how much tightening the Bank of England delivers this year. A hike in May will make four back-to-back increases, so we expect a pause after that. This reflects the view that the slowdown in the economy will be enough to take some of the heat out of the labour market and wage growth.

But there’s clearly a risk that the job market will continue to tighten. If that happens, we expect the Bank to continue its rate-hiking cycle in the second half of the year, although the pace of tightening would probably slow somewhat relative to the Bank’s current trajectory.