25 Mar 2014

Will falling UK inflation mean a boost to our pay?

Inflation has fallen to its lowest level in more than four years – good for households who have seen their pay eroded by rising prices, but the better news is the squeeze on earnings may be over.

The inflation rate in February was 1.7 per cent – down from 1.9 per cent the previous month, writes Economics Producer Neil Macdonald.

The problem for households (and politicians) since the end of the 2008-09 recession has been the failure of earnings to keep up with rising prices. So if your pay goes up by 2 per cent over a year, you have more cash in your pocket.

But if at the same time, the cost of what you buy rises by 3 per cent, then in real terms you are worse off. It is that squeeze on real earnings that has defined – and limited – the UK’s economic recovery.

The chart above – from Chris Williamson at Markit – shows how extraordinary the era we have been living through has been.

He has taken the inflation rate away from the average growth in earnings to show us the real growth in earnings. When the line is above zero, then on average the country is seeing a real growth in earnings. When the line is below zero, our pay is shrinking in real terms.

Flip in fortunes

The chart shows a remarkable flip in our fortunes. From 2002 to 2008, pay is growing consistently faster than inflation – on average, we are getting better off. Then in 2009, things change and from 2010, pay consistently and relentlessly falls in real terms.

If we see growth of wages and salaries pick up sharply in coming months, concerns about the feed-through to higher inflation will intensify, as will the pressure on policymakers to take some of the heat out of the economy via a first hike in interest rates. Chris Williamson, Markit

Real earnings have fallen for the entire period that the coalition has been in power. And that of course is why Labour goes on so much about a cost-of-living crisis and why the coalition to so keen to show it is doing something about this – whether by not raising fuel duty or raising the personal allowance or even cutting the duty on beer.

This squeeze has come from two directions. Pay growth has been low because demand in the economy has been weak. Companies could have cut costs by sacking people. Instead, people have stayed in their jobs by agreeing to either a wage freeze or even a wage cut.

At the same time, inflation has been strong thanks to many factors, including a jump in oil and food prices, a decline in sterling (which tends to push up the price of imported goods) and the government’s decision to raise VAT as part of its drive to improve the public finances.

Living standards

Both sides of the squeeze equation have been improving recently – and the significance of the chart is that the black line now seems to be heading decisively back towards positive territory. If that happens, then the squeeze on living standards would finally be over.

The question is – when will it happen? Chris Williamson believes it may have happened already.

That is because today’s figures show inflation in the year to February. But the earnings figures produced by the Office for National Statistics – and used in the graph – show the growth rate for the three months to January – so they are lagging the inflation numbers.

Inflation has fallen to its lowest level in more than four years - good for households who have seen their pay eroded by rising prices, but the better news is the squeeze on earnings may be over (G)

When you take the three month earnings figures and split them out on a monthly basis, you find that pay growth in November was just 0.8 per cent, but in both December and January the growth was 1.7 per cent.

When the data comes through for February, Chris Williamson suspects that – even with no further improvement in the labour market – we will find that earnings growth is now matching inflation.

Turnaround

And even this may be playing down the strength of the turnaround. The overall figures include the public sector, where pay growth is very low because of the government’s pay restraint policy.

For those in the private sector, pay is already rising faster than inflation and – in some areas – dramatically so. In manufacturing, wages grew by 3.9 per cent in the year to January. In construction, they grew by 6.1 per cent.

There is evidence that wherever demand is strong and there is a shortage of skilled, experienced staff, wages are responding.

Dark cloud

There is one dark rain cloud in this rather sunny outlook. For many companies, wages are the largest element of their costs. So if wages are growing strongly, they might be tempted to try and pass on those higher costs by raising their prices.

If that happens, today’s benign inflation news may change and that could mean the Bank of England deciding to raise interest rates.

As Chris Williamson told Channel 4 News: “If we see growth of wages and salaries pick up sharply in coming months, concerns about the feed-through to higher inflation will intensify, as will the pressure on policymakers to take some of the heat out of the economy via a first hike in interest rates.”