Tighter labour market makes February rate hike more likely

The drop in employment in December won’t be enough to prevent the Monetary Policy Committee (MPC) raising interest rates again at its next meeting in March. In fact, the rise in wage growth will fuel the MPC’s concerns about a tight labour market – keeping wage growth above the level it feels is consistent with its inflation target, which makes a rate hike in March more likely.

Omicron took some heat out of the labour market in December. There was a 38,000 fall in employment in December, but that wasn’t enough to change the unemployment rate, which remained at 4.1%. We expect the labour market to continue to tighten over the rest of this year, but at a slightly slower pace as gains in employment start to run up against a smaller post-pandemic workforce. The unemployment rate is likely to be back below 4% by the end of the year. Indeed, the 108,000 rise in payrolls and 31,900 drop in the claimant count last month suggests that job creation picked up again at the start of the year.

We expect the labour market to continue to tighten over the rest of this year, but at a slightly slower pace as employment gains start to run up against a smaller post-pandemic workforce – the 287,000 increase in the number of ‘inactive’ people since before the pandemic has been driven mainly by a 237,000 increase in the number of people on long-term sick leave. This may be an after-effect of the pandemic, but any easing will be only gradual. Combined with lower inward migration as a result of Brexit, the UK’s workforce is likely to grow more slowly than it did before the pandemic.

Real pay will fall further

At the same time, headline pay growth rose from 4.2% 3myy in November to 4.3% in December, well above its pre-pandemic level of about 3%.

Most of the distorting factors that had been pushing headline pay growth up have worked their way out of the data, but real pay growth, which takes inflation into account, is now negative and we expect it to remain that way for most of 2022. This will reduce consumer spending, especially at the lower end of the income distribution, where households spend a larger share of their income on utilities, the price of which has soared. Real household disposable incomes are likely to fall by around 2% in 2022, and if Russia invades Ukraine the subsequent spike in inflation could mean real incomes drop by about 3.5% – the hardest squeeze on spending power on record.

The policy takeaway

For the first time since 2004, the central bank delivered back-to-back rate hikes at its December and February meetings. Following its decision in February, the Bank signalled its intention to tighten monetary policy again in coming months if the economy evolved broadly in line with its forecasts. Today’s data suggest its projections remain on track.

As a result, we continue to expect the next rate hike to come in March, probably followed by another one in May.

However, that may be the last move for a while and we expect the benchmark rate at the end of 2022 to rest at 1.00%. That’s because slower wage growth, negative real incomes, and the possibility of inflation dropping below target in 2023 if energy prices fall are all reasons for the MPC to tread carefully before it lifts rates again.