Higher wage growth has not fuelled inflation – but it will if productivity does not improve
Strong wage growth has been a major concern for the Bank of England as it considers when to start cutting interest rates.
Real wages have grown by around two per cent in the year to February, according to the Resolution Foundation, meaning wages have grown roughly as much in the past year as in the period since the financial crisis.
Despite stronger real wage growth, productivity – which measures workers’ output per hour – has actually deteriorated in the past year.
Productivity is the main determinant of real wage growth in the long run. Without increases in productivity, wages cannot rise sustainably without causing inflation.
Recently, however, a couple of countervailing factors have allowed firms to manage higher levels of wage growth without having to increase prices.
The first is that higher interest rates have reduced the need for employers to put extra money in Defined Benefit pensions schemes, reducing the amount that firms have to pay out on top of their wage bill.
Secondly, the UK’s terms of trade have mostly recovered following the impact of the Russian invasion of Ukraine, when import prices surged relative to the price of exports.
Over the past year import prices have fallen by 2.9 per cent, compared to a 0.1 per cent fall in export prices, giving UK firms and consumers greater spending power.
“Just as the terms of trade shock made Britain poorer beyond its control during the cost of living crisis, its partial unwinding is now making us richer without the need for productivity rises,” the Resolution Foundation said.
There’s no guarantee that the UK’s terms of trade will continue improving and pension contributions won’t fall forever.
Greg Thwaites, research director at the Resolution Foundation, warned that without addressing the UK’s stagnant productivity performance, inflationary pressures would eventually arise.
“Unless productivity picks up, wage growth will peter out, or pay rises will simply be passed on through higher prices and prolong our inflation problems,” he said.
The latest wage and jobs figures are due out tomorrow morning, with economists expecting a slight easing in wage pressures.