How are inflation and jobs connected?
There’s a straightforward and fairly widely accepted link. When unemployment falls below a certain point – the stage at which pretty much everyone who wants a job either has one or is between jobs – it tends to result in upward pressure on wages. Since workers are scarce, companies and other employers are forced to nudge up the salaries they pay to attract them, which in turn puts upward pressure on costs and demand, and ultimately on the price of goods and services – a classic inflationary spiral. This critical level of unemployment, which isn’t a constant, but varies over time, is known as the “non-accelerating inflation rate of unemployment” or NAIRU. Above this critical joblessness rate, inflation won’t accelerate; below it, price rises are on the way. The US Congressional Budget Office and the UK’s Office for Budget Responsibility (OBR) each publish regular calculations of NAIRU.
Where’s NAIRU now?
Lower than it has been for years – according to the OBR’s most recent analysis (March 2018) – but there’s scant sign of wage inflation. From 2011 and 2014 the UK’s official NAIRU estimate remained broadly constant at 5.4%. But unemployment just kept falling. In the absence of rising wage pressure, the OBR has been obliged to make successive downward revisions in the past three years. Last November it slashed it to 4.5%.
But isn’t unemployment now even lower?
Yes. At 4.2%, it’s the lowest since the mid-1970s, while the employment rate is at a record high of 75.7%. In other words, it would be hard to imagine a tighter labour market, and we should expect wage inflation to kick in hard. But that’s not what’s happening. General price inflation is picking up, but that’s largely down to rising oil prices and renewed weakness in sterling. The annual growth rate in total pay over the past three months has been just 2.5%, the weakest since last November.
And in previous cycles?
That’s in stark contrast to the 1970s, say, when joblessness of 4.2% was accompanied by pay growth of well over 20% – or even to the 2000s, when unemployment was slightly higher than now and earnings growth was 4.5% to 5%. A similar pattern can be seen in the US, where joblessness is even lower, at an astonishing 3.8% in May (and 4% now). In both economies unemployment keeps falling below the supposed NAIRU, yet wage growth has been relatively subdued.
So what’s going on?
There’s “no real mystery” as to why the relationship between unemployment and wage inflation appears to have broken down, according to Jeremy Warner in The Sunday Telegraph. In a word: globalisation. New technologies, mass migration of workers, and a rise in international trade have all combined to “ease the supply problem that typically arises when unemployment gets ‘too low’”. These days, it’s far easier for firms to switch production to other jurisdictions if labour costs rise too high for comfort. And if they can’t switch production, sales may be undercut by cheaper imports if costs make a firm’s goods uncompetitive. At the same time, the labour market in rich countries has changed, with fewer unionised jobs, fewer jobs requiring middle-range skills, and more people in lower-skilled, lower-paid jobs where bargaining power is weak. Younger workers are accepting lower-wage service jobs, while older, better-paid staff are retiring, a trend that tempers pay gains.
What about productivity?
Productivity has been unusually subdued in this cycle, militating against pay rises, but the problem has been compounded by non-wage labour costs. As David Smith points out in The Times, high non-wage labour costs prevent employers being generous with salaries. Sickness, maternity and paternity pay, national insurance, pension contributions, the apprenticeship levy and the national living wage are all relevant factors. Non-wage costs have been climbing twice as fast as wages recently. Throw in poor productivity and the question is not why pay growth has been so weak, but “why it has not been weaker”, says Smith.
When will inflation come back ?
In the US, commentators such as Barry Ritholtz of Bloomberg argue that the labour market is now so tight we should expect wage inflation to accelerate. There are now fewer job seekers than jobs and a record number of people are leaving their jobs, which usually happens because they have found a more lucrative one. We have finally reached the stage when employers will have “no choice but to pay more to attract and keep workers”, he says. In Britain, too, the labour market is extremely strong and recruiters are having more and more trouble getting the people they need.
What about the next cycle?
There are several structural trends that also suggest a reversion to the historical mean is due. Labour costs in China and other parts of the developing world are rising as their domestic economies strengthen. “This ought eventually to relieve some of the pressures on the advanced economies,” says Warner. An outbreak of protectionism will reduce cheap imports. The ageing population means the labour force is shrinking, so scarcer workers will have more wage-bargaining power. Artificial intelligence should (counter-intuitively) help wages in the long-run, because it will ultimately drive a “productivity miracle that will profoundly improve living standards”. In both the long and short term, then, NAIRU looks set for a comeback.