Why pay growth won’t be increasing anytime soon

Optimism about prospects for pay this year seems already to have dissipated.  The latest CIPD Labour Market Outlook survey, published on Monday, reported a downward move in employers’ forward-looking pay expectations, with the median pay change falling from 2% to 1.2%.  According to XpertHR, the median pay rise anticipated during the 2015/16 pay round among the private sector employers they surveyed was 2%, unchanged from last year.  The latest labour market statistics show that the headline measure of average weekly earnings growth closed 2015 at 1.9%, with higher figures earlier in the year not being sustained.

This is being recognised to a degree by forecasters.  The latest Bank of England Inflation Report revised its forecast of average earnings growth in the final quarter of 2016 down from 3.75% to 3%.  Professor Kristin Forbes, one of the independent members of the Monetary Policy Committee acknowledged in a recent speech that wage forecasting models were not working well.  It remains to be seen whether the Budget will see the Office for Budget Responsibility change their forecast of average earnings growth reaching 3.4% by the end of 2016.

Forecasters still expect wage growth to get to 4% or so - which is what you’d expect in the medium-term given a 2% inflation target and some reasonable assumptions on productivity.  As a result, the Bank expect wage growth to reach 3.75% by the end of 2017 and 4.25% by the end of 2018.

This return to 'normality' has been just around the corner for a few years.  What if it stays just around the corner?  Maybe forecasting models haven’t performed well of late because the assumptions about how the labour market works embedded in them have changed in subtle ways?  What if wage growth continues to trundle along at about 2%?  Why might this happen and what could push or pull wage growth onto a higher trajectory?

UK wage growth: corridors and staircases

Consider the Labour Market Outlook data on forward-looking wage expectations, shown in the chart below.

The median pay change (not increase, because the data includes employers intending to freeze pay) has consistently been within the 1-2% range, shown by the bars always being within the range marked by the two orange lines (of which more to come!).  It seems that a pretty good predictor of current pay expectations is what employers were predicting last quarter or last year.

The Office for National Statistics (ONS) measure of short-term earnings growth suggests that pay outcomes are also quite stable most of the time.

The chart above shows the annual growth rate of average regular pay since 2001.  This excludes bonuses which amount for quite a small proportion of total pay.  Between 2001 and 2008, earnings growth was almost always within a 3-5% corridor (again, within the orange lines).  There was then a sharp downwards adjustment during 2009 before the reappearance of a corridor in 2010, but now at the lower range of 1-2%.  Yes, earnings growth was above 2% for quite a few months in 2015, but this was one year after a period when earnings growth was unusually low.  Such ripples in growth rates are often the result of changes in the timing of pay rises and bonus payments, rather than changes in their size.

These wage growth corridors are also present in measures of pay settlements, as shown in the chart below.

Private sector settlements have exceeded 2% on a number of occasions since 2010 but public sector pay restraint has kept the median increase in the 1-2% range.  Note these data are not representative of the economy as a whole, being disproportionately large and unionised organisations where a ‘pay round’ is part of the furniture.

Nor are these patterns new.  The Average Weekly Earnings series commences in 2000.  However, the ONS have produced a historic time series for average earnings running from 1964 to 2010, as shown below.  The ONS warn that this series may not be entirely consistent over time; there is also more short-term variation, partly due to bonuses being included (which is why there’s such a large negative figure in early 2009).

Earnings growth during the 1960s and 1970s was up and down like a rollercoaster.  This was thanks to a combination of high inflation and government incomes policies.  Falling inflation and a severe recession saw earnings growth fall from over 25% in September 1980 to under 9% by January 1983, when the orange lines commence with a relatively wide corridor of 6-10% (that sounds wide by today’s standards but any Chancellor in office between 1964 and 1979 could only dream of such regularity!).  Wage growth slowed down rapidly during the early 1990s recession before the corridor re-emerges, this time with the 3-5% range that stayed in place right through to 2008 ...

Why is wage growth so stable?

Economists have long recognised the significance of downwards wage rigidity, the idea that wages rarely fall in money terms because of worker resistance.  Downwards wage rigidity can lead to unemployment.  The tendency of wage growth to remain within a fairly limited corridor for long periods suggests there could also be some upwards wage rigidity.  In other words, forces that encourage inertia and prevent wage growth from breaking out of the corridor.

The notion of the ‘going rate’ works in just this way.  Wage increases at the organisation level tend to cluster around a ‘going rate’.  Nor does the ‘going rate’ change much from one year to the next, because it’s based on wage increases that themselves are clustered around previous ‘going rates’.

When more of the economy was covered by collective bargaining, the ‘going rate’ took centre stage: for example, the pay settlement at Ford’s acted as a target or guide for many unionised industries.  Nowadays, pattern bargaining of this type is rare.  However, many organisations – with or without collective bargaining – still set pay in relation to their understanding of what others in the market are paying.  Often they are helped in this by remuneration consultants who provide advice on the distribution of pay increases paid by comparable firms and the implications of being upper quartile, lower quartile or somewhere between the two.  The process sustains itself: a pay outcome influenced by the current distribution then becomes an additional data point in that same distribution …

Employers have good reasons to cluster around a ‘going rate’.  If an employer awards a pay increase well below it, there might be a saving on labour costs but worker discontent is pretty much guaranteed.  This is something not done lightly unless business conditions are bad (and employees recognise things are bad).

There is as much risk involved in paying well above the ‘going rate’.  The difference is profit foregone, unlikely to go down well with shareholders.  And a high pay increase won’t attract many high-quality workers from other firms because those already employed are going to stay put.  This doesn’t seem a sensible course of action unless an employer is planning to expand, or the existing workforce are stellar performers and worth keeping at any cost.

The ‘going rate’ also works for employees.  The absolute pay rise isn’t the only thing that matters to them; at least as important is its value relative to colleagues, friends, neighbours etc.  Nor is this relativity effect symmetrical: the negative effect on people who think they are paid less than their reference group is far stronger (and persistent) than any positive effect felt by those who get a higher than average raise.  Furthermore, quitting a low-paying employer for one who pays a bit better is always a gamble.  Most employees are therefore unlikely to resist being paid the ‘going rate’, even when this means a pay cut in real terms, because everyone’s in much the same position.

In addition, textbook models of the labour market may encourage us to underestimate the extent to which supply pressures can be accommodated without increasing aggregate wages.  Simple models often assume that average hours worked are constant and the size of the population is fixed, at least in the short term; hence changes in the amount of labour supplied can only arise through more or less people not being employed (unemployed or inactive).  The usual assumption is also that the wage rate paid to all workers is that required to attract the marginal hire.

These assumptions look increasingly unrealistic.  Some fluctuations in labour demand are met by changing average hours through overtime or short-hours working.  More important, though, is the increasing prevalence of contingent forms of work, such as zero-hours contracts, freelancing, sub-contracting and the like.  These mean employers can scale their use of these types of labour up and down, often at very short notice, and with no need to adjust pay rates.  Nor is the population fixed; migrants, especially those from elsewhere in the EU, are an easily accessible pool of labour.  And even if a higher wage is necessary to attract new recruits, there’s no guarantee this will lead to an across-the-board pay rise.  On the contrary, employers are likely to do this only when there’s no way of avoiding it.  So a higher wage offer might be described as an allowance or discretionary payment.  And with a widespread culture of pay secrecy, employees may never find out anyway.  As a result, some widely-used measures of excess capacity, such as the unemployment rate, may be (increasingly?) incomplete indicators of the pressure on employers to deviate from the ‘going rate’.

There are additional factors currently in play which make an acceleration in wage growth even less likely.

Labour productivity, measured by output per hour worked, has hardly increased since 2008.  If the value produced from each hour worked is not increasing, it’s difficult to sustain real terms wage growth.  The second and third quarter of 2015 did see reasonable productivity growth, but it seems likely this hasn’t persisted into the final quarter of 2015.

Non-wage labour costs, especially employer pension contributions, have risen faster than wages over time.  The (experimental) ONS index of labour costs per hour reports an increase in hourly wage costs of 58% between 2000 and the third quarter of 2015; the corresponding increase in non-wage labour costs is 94%.  Employers will pass some of these non-wage labour costs onto employees through lower wage rises.

Further imposed increases in labour costs are on the way.  The National Living Wage comes into force on 1 April this year, increasing the minimum wage rate for those aged 25 and over by 7.5%, with the prospect of further significant rises in the rate in each year until 2020.  Auto-enrolment of pensions is still being rolled out to smaller firms and there is also the likelihood of increases in the minimum contribution rates later this Parliament.  The introduction of the Apprenticeship Levy in April 2017 is another potential cost: it will be set at 0.5% of payroll costs.  Most smaller businesses are unlikely to face any additional cost and the net impact on larger organisations will depend on the extent to which they are able and willing to take on apprentices.  CIPD surveys show that an increasing proportion of employers are identifying these cost increases as a reason why they are keeping wage increases below 2%.

Affordability also continues to be an important constraint on wage growth for many organisations.  This has always been the case in the public sector; in addition, according to the latest Labour Market Outlook, 41% of private and voluntary sector organisations whose last pay award was below 2% cited affordability as a factor.  The median pay increase awarded during the past 12 months by private and voluntary sector employers who said their financial performance was better than average was 2%, whereas it was 1.5% for those who said their performance was average and zero for the small proportion of employers with below average performance.  While it is true that UK companies have accumulated increasing cash and equity holdings, analysis by the Bank of England suggests this is largely for structural reasons and doesn’t necessarily mean there’s cash available for higher pay.  A significant proportion of companies are making little profit or running at a loss.  We hear less about zombie companies these days but there hasn’t been an increase in company liquidations during the economic recovery, so many must still be there, lurking in the wings.  While firms may not want to pay higher wages than they have to, it will sometimes be a case of ‘can’t pay’ rather than ‘don’t need to pay’.

If productivity growth remains low, interest rates remain low, and labour supply continues to grow by enough to prevent widespread labour shortages, wage growth could remain in its current 1-2% range for some time – perhaps for the rest of the decade or longer.  As long as inflation remains at or below its 2% target, that would imply modest increases in real wages, although probably not enough to bring the real value of average earnings back to its pre-recession peak any time soon.

Pressing the reset button

What might change this?  What might trigger a corridor reset?  It is of course impossible to identify all the events, and combinations of events, capable of doing this.  Recent UK experience has been that wage norms get reset (downwards) during recessions and the UK economy will, of course, go into recession at some point.  However, the scope for further downwards movement may be limited if the current norm is 1-2%.

Another possibility would be if there is a sharp increase in inflation.  This discussion has focused on nominal wage growth rather than real wage growth.  Small changes in inflation – when inflation is already low – don’t appear to make much difference to nominal wage growth.  Pay negotiators may focus on changes in the various measures of inflation – when it suits their case – and there are some pay deals anchored to measures of inflation, but these arrangements directly cover a relatively small proportion of total employment.  But it’s possible to imagine a large and unforeseen change in inflation – from 2% to 5%, say – triggering higher wage rises, especially if this occurred when demand was strong.  Whether these became embedded into a “new norm” would depend on whether or not the increase in inflation was regarded as a one-off.

An increase in the inflation target probably would lead to a matching increase in wage norms.  Governments periodically review the mandate of the Monetary Policy Committee and the Shadow Chancellor is currently conducting his own review.  If there was an upwards adjustment of the target – from 2% to 4%, say – this would almost certainly feed through into pay increases, although there would probably be no impact on real earnings.

Otherwise, the ability of government to push up wage growth is limited.  An aggressive series of increases in the minimum wage could raise wages at the bottom, but would have little effect if employers reacted by squeezing the wages of those higher up the wage distribution or by cutting jobs.  Ending pay restraint in the public sector would be unlikely to trigger an explosion of ‘catch-up’ pay rises unless the government acquiesced by funding them, unlikely given the long-term pressures on the public finances.

A higher and sustained rate of labour productivity growth would create the conditions for a higher and sustained rate of wage growth.  Whether wages actually increased would depend on the source of higher productivity growth, which is not always easy to determine even retrospectively.  If productivity increased due to the diffusion of new technologies, for example, the effect on wages would depend on whether technological change displaced human labour or worked most effectively in combination with humans; in practice, some types of labour would probably benefit and some would be displaced, meaning the effect on the wages of individuals would also vary.  This is why some commentators on the future of work emphasise the need for a greater redistribution of income.

Wages are a price for services provided.  Like all prices, they do reflect supply and demand.  But the size and speed of adjustment, in particular, appear to be uneven.  Sometimes wages appear disconnected from the market; but when conditions demand it, adjustment can be rapid.  The UK has also seen significant changes in the relative earnings of different occupational groups.  However, the ‘going rate’ means these changes can take a long time to become visible above the noise.  For the employers and employees potentially affected, ‘we’ll have what they’re having (give or take a small amount)’ might not be so bad after all?

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