Why wage growth hasn’t joined in the recovery

Earnings growth has been disappointing since the crisis 

The UK appears to be in rather good nick. It has taken a long time, but many of the indicators of an economic recovery are now in place.

The economy is back at its pre-crisis size, even accounting for a larger population. The jobless rate is at its lowest in a decade, and the employment rate is at a record high.

However, wage growth, which once averaged more than 4pc a year, has averaged less than half that since the financial crisis.

At the beginning of last year, the Bank of England believed earnings would rise by an average of 3.5pc in 2015. In their most recent update, the central bank's economists recognised that the gains were likely to be below 2pc.

Kristin Forbes, one of the nine people responsible for setting the Bank of England’s rates, admitted in a recent speech that the forecasting models used by the central bank had “not been working very well”.

The disappointment is not felt just by economists, and the employees receiving meagre pay awards, but also by those hoping for interest rates to rise. The Bank of England has been waiting for inflation to kick off before it is willing to raise interest rates. Specifically, policymakers want to see evidence that it is returning towards their 2pc target for inflation.

It is has long been thought that as the number of people looking for work falls, wages will have to rise, and in turn, so will prices. This process is the erosion of “spare capacity” in the jargon, ensuring that all those who want to work do so, and leaving as few resources unemployed as possible.

Mark Carney, the Bank of England’s Governor, has ruled out an imminent interest rate rise, explaining that he wishes to see “growth momentum” that will erode this spare capacity.

The UK central bank has relied on the so-called “Phillips curve”, a relationship between unemployment and inflation, to determine when inflationary pressures will arise. Several factors seem to have weakened this relationship, as the impact of a fall in joblessness on inflation has dulled.

Many explanations have been put forward. The Bank of England has described structural shifts in the UK’s jobs markets. We are working later in life, and longer hours, for instance. To a lesser extent, rising migration has also dampened overall pay growth. These might account for knocking a percentage point off total wage growth, central bank staff have said.

It has even been suggested that the crisis has left long-lasting scars on younger employees, who have become hesitant to ask for a pay rise, never having got into the habit of demanding a better deal.

While Forbes believes that the British jobs market has now “largely returned to normality”, one of her predecessors is less than convinced. David Blanchflower, who once served on the MPC, dismisses the aforementioned structural shifts.

“If your employer thinks you are going to leave, they’re going to give you a pay rise,” he says. However, people aren’t quitting their jobs, seemingly because they realise that there is not an abundance of preferable jobs available.

Blanchflower argues, alongside University of Stirling professor David Bell, that it is not the jobless rate that matters, but the still high level of UK underemployment. This adds in those who say they want to work fewer hours, and the greater numbers who say they want more.

Pre-2008, underemployment and unemployment tracked each other closely. However, since the global downturn struck, they have diverged, as there are not as many hours to go around as workers would like. Blanchflower says that this failure is responsible for weak wage growth.

Now an economics professor at Dartmouth College, New Hampshire, Blanchflower believes that underemployment is the measure of slack the MPC should be considering.

Economists also believe that globalisation has helped to keep wage growth low. As goods and people have been able to move more freely, domestic conditions have taken a back seat in determining inflation’s speed. Movements in inflation ripple freely across the globe, unlike in the past.

Traditionally, an employer facing a tight jobs market might be forced to pay higher wages to hire and retain staff. That same employer can now more readily attract workers to the UK, or to set up operations in another country, where lower wages might be paid, helping to keep a lid on inflation.

As such, the problem is not unique to the UK. Mario Draghi, the president of the European Central Bank, has said that in a world of very low inflation, cheaper energy prices could have pernicious “second round effects” in the euro area.

Goldman Sachs describes momentum in eurozone wage growth as “soggy”. It warned that cheap commodities and inflation might feed into the expectations of wage-setting firms, such that “a ratcheting-down of inflation could take hold”.

All this means the Bank of England may face difficulties if it wants wage growth at the sort of levels necessary to achieve its inflation target Blanchflower believes that real wages, rather than beginning to rise, will be weaker in the months to come, as inflation rebounds from near-zero.

The Bank of England is more optimistic. It believes that average wage growth will gather pace to 3pc this year, or just over 2pc after inflation. We can only hope that it will be right this time around.