UK Wage and Price Inflation and the Middle East Conflict

So, what does the data suggest is going on with wage and price inflation at the moment?

As I noted in last week’s Wage Tracker, the latest ONS wage data indicate that the annual growth rate of average weekly earnings, including bonuses, was 8.1 per cent in the three months to August. Excluding bonuses, average pay growth was 7.8 per cent– representing one of the highest annual regular pay growth rates recorded since comparable records began in 2001. Both AWE figures sit well above their series average growth rates of 3.2 and 3.1 per cent, respectively, indicating that economy-wide wage inflation is elevated.

We can break down the economy-wide data by sector. In the private sector, total AWE (including bonuses) grew by 7.1 per cent in the three months to August relative to the previous three-month period, while in the public sector, total AWE growth was 12.5 per cent. The latter figure represents the highest total average pay growth in the public sector recorded since comparable records began, though this figure is largely driven by one-off bonus payments. In line with the trend in economy-wide AWE growth, these sector-specific figures sit well above their series average growth rates of 3.3 and 3.1 per cent, respectively.

While economy-wide and sector-specific measures of average pay growth are high – and have been higher than their historical averages over the past year – when we account for inflation, wages have only been rising for the past three months, following a year of wage cuts. Economists use the term ‘real wages’ to describe inflation-adjusted wages.  In the three months to August, total real AWE grew only by 1.2 per cent. This means that, when we take inflation into account, the soaring figure of 8.1 per cent average total pay growth falls over sixfold. In the private sector, real total AWE growth was 0.4 per cent in the three months to August, while in the public sector this figure was 5.5 per cent, driven by one-off bonus payments. It is therefore important when talking about recent wage inflation to take into account the fact that workers had been taking real pay cuts for over a year before starting to see inflation-adjusted wage growth, on average, from June onwards.

The latest ONS data suggest that consumer price index (CPI) inflation held steady at 6.7 per cent in September. As I noted in the latest CPI tracker, this figure reflects decreases in the annual rates of inflation of items such as food and alcoholic beverages, and furniture and household goods, being offset by price rises in motor fuels and categories such as transport and education. While CPI inflation has been falling gradually since peaking at 11.1 per cent in November 2022 (driven largely by the inflationary effects of Russia’s invasion of Ukraine), this latest figure remains well above the Bank of England’s target of a 2 per cent inflation rate for the 26^th consecutive month.

How do we see wage and price inflation developing over the medium run and what does that mean for monetary policy? 

There are several factors that contribute to wage inflation in the private sector. For instance, if workers expect that inflation will be high next year, they will be more likely to demand higher pay growth to protect their real incomes. Equally, if workers have an increased ability to bargain for higher wages, then we might expect wage inflation to remain elevated in the medium-run. The latest ONS data tells us that there were 1.4 unemployed people per job vacancy, on average, in the three months to July. This compares to a series average of 2.9 for the unemployment to vacancy ratio. This ratio indicates that workers have a historically high ability to bargain for higher wages; therefore, we might expect wage inflation in the private sector to remain elevated in the medium-term.

Research done by my NIESR colleagues suggests that wage growth in the public sector adjusts to wages set in the private sector. In this sense, the elevated wage growth in the past few months seen in the public sector can be interpreted as an overdue ‘catch-up’ needed to retain staff, particularly those in high-skilled positions. As such, we might expect public sector wage growth to remain elevated alongside private sector wage growth over the next year.

Core CPI inflation is a measure of inflation that excludes food, energy, alcohol, and tobacco, which are all items that see volatile price changes, and serves to give us an underlying sense of where inflation ‘really is’ and where it might be going. Core CPI inflation was 6.1 per cent in the year to September, falling marginally from 6.2 per cent in August. This measure tells us that underlying inflationary pressures remain very elevated in the United Kingdom, and thus inflation may continue to exhibit persistence (i.e. fall more gradually than expected) in the medium-term.

That said, the Bank of England has set interest rates to 5.25 per cent in order to bring inflation down to its 2 per cent target in the medium-term (i.e. around two years’ time). Conditional on future inflationary developments, it is likely that the Bank has done enough achieve this target. According to a recent ONS study, despite elevated wage growth, there is very little risk of a wage-price spiral in the United Kingdom (where wage inflation leads to price inflation which leads to wage inflation again, and so on). Further, ONS findings suggest that wages have contributed to inflation in a similar way in the past year as in historical data.

Taken together, it seems to be the case that a tight labour market will likely enable high wage growth in the medium-term, but the economy should be able to accommodate this via reduced profit margins or further persistence in inflation. Still, we can expect inflation to return to its 2 per cent target in the medium term.

To what extent might that change if the conflict between Hamas and Israel were to widen out?

The ongoing conflict between Hamas and Israel is a terrible human tragedy that has led to the unjustifiable deaths of hundreds of innocent civilians in Israel and Palestine. My thoughts are foremost with all the victims of this horrible war.

A secondary consequence of this conflict, or any further escalation of it, is the risk of another inflationary shock. As my colleague Paul Mortimer-Lee wrote in this Central Banking article recently, “there is a concrete risk if the situation deteriorates that Middle Eastern energy producers could physically restrict supplies to supporters of Israel and cut production to push up prices”. Similar to the aftermath of Russia’s invasion of Ukraine, such a shock to oil prices would lead to an inflationary shock in many countries. If this were to happen, price inflation would rise, leading to ‘second-round’ inflationary effects including rising wage inflation.