Will 2014 be the year of the pay rise?

This morning I took part in an event at The Resolution Foundation looking at the UK pay outlook for 2014 and beyond. My fellow panellists were David Smith, Economics Editor at the Sunday Times, Nicola Smith, Head of Economics and Social Affairs at the TUC, and Ian Stewart, Chief Economist at Deloitte. The Foundation’s chief economist Matthew Whittaker provided a statistical background to the discussion, covering the various available data sources and charting recent trends in real and nominal earnings, and the Foundation’s Chief Executive Gavin Kelly moderated debate between the panellists and other attending participants.

The opening contributions from the panellists and subsequent questions from the floor provoked a wide-ranging discussion. Here is my initial contribution:      

“When last December I published my labour market projection for 2014, I concluded that this would be a ‘year of slim pickings’ for most UK workers.

By this I meant I expected to see an increase in the rate of growth of nominal regular pay (on the measure of average weekly earnings, excluding bonuses, as published each month by the Office for National Statistics) that would be sufficient to enable growth in pay to outstrip CPI inflation. This might not be enough to make workers feel much better off but it would mark the end of the post-recession fall in average real earnings.  

Some commentators thought this too pessimistic a view, other too optimistic. On what premise therefore do I base what is thus best described as my relative optimism?

For most of the period since 2008 the UK labour market has had to deal both with the effects of a large and prolonged deficiency in aggregate demand for goods and service in the economy and a large increase in the effective supply of labour. Given the UK’s current configuration of labour market and welfare institutions, a far greater than usual part of the market response to these changes in demand and supply has emerged in a fall in real wages, with a correspondingly smaller than usual part emerging as a rise in unemployment.

Although the fall in real wages has supported demand for labour and employment – a socially preferable form of adjustment – it has not supported aggregate demand and output, resulting in the much commented upon fall in labour productivity. Given this it is my view is that both the fall in real wages and productivity in recent years - sometimes referred to as ‘the productivity puzzle’ - is entirely the consequence of the prolonged deficiency of aggregate demand.

The corollary of this conclusion is thus that a substantial and sustained increase in aggregate demand will eventually restore the labour market to the same combination of employment, real wages and productivity (and by extension rates of growth in these variables) prevailing prior to the recession.

This raises three questions to each of which I will here offer a brief answer:

1.     When might we see the first signs of the move back to the pre-recession norm?

2.     How long might this process take?

3.     And should we be satisfied with the norm to which we will return?

My answer to the first question is sometime this year, given that we have already passed a tipping point in the pattern of employment growth, with demand for labour now being increasingly driven by an improvement in aggregate demand for goods and services rather than solely the (lower) level of real wages.

In this respect it’s useful to remind ourselves that the substantial and surprising rise in UK private sector employment since 2010 was for much of that time primarily the result of an unusually low outflow rate from employment rather than any marked increase in the rate of hiring. The level of job vacancies remained remarkably low during the period of the so-called ‘jobs boom’, much lower than before the recession, which explains why strong employment growth had until quite recently only very a muted effect on unemployment, especially youth unemployment.

However, since around the spring of last year, when a rise in aggregate demand for goods and services began to show a noticeable improvement (as evident in far stronger growth in real GDP), there has been a sharp and sustained rise in in the level of job vacancies, which is now approaching the pre-recession level, and a much faster fall in the rate of unemployment. Moreover, independent employer surveys suggest that this improvement is continuing as we move further into 2014.  

A rise in vacancies relative to unemployment is almost certain to put upward pressure on nominal pay growth. Whether this will be enough to result in real wage growth this year is, admittedly, uncertain. The job matching process looks to be working really well, contrary to popular wisdom the incidence of skills shortages is low, and actual unemployment (at around 7% of the active workforce at the end of 2013) is still far in excess of most estimates of the NAIRU (i.e. the normal, or underlying structural rate of unemployment). All this suggest that it may take quite a lot of momentum to provide any real oomph to pay,  and we certainly shouldn’t expect to see anything that could be described as ‘wage inflation’ for a long while yet. But a growth rate of regular weekly earnings moving upward toward CPI inflation is not a totally unrealistic expectation for 2014.    

Either way I expect more momentum on relative wages this year than at any time since the start of the recession, with an increase in job vacancies providing improved opportunities for individual workers with aptitudes most attractive to employers. These workers will benefit from a combination of better pay offers to attract them away from their current employers and counter offers to persuade them to stay. This should raise mean earnings, if not necessarily median earnings.

As for my second and third questions, it’s probably not unreasonable to expect a return to normality by the end of this decade, though this depends crucially on the sustainability of the present recovery in aggregate demand and the degree to which both monetary and fiscal policy support growth. But however long it takes you’ll probably gather from what I’ve said that I don’t think we are looking at a so-called long-run ‘new normal’ that is significantly worse in terms of employment, real wages and productivity than experienced prior to the recession.

Rather than concern ourselves with the ‘new normal’ debate, my view is that we should instead be reviewing whether we should be satisfied with a return to the ‘old normal’. The immediate pre-recession years may have looked good in terms of structural unemployment but were nonetheless characterised by low productivity in many sectors of the economy and correspondingly modest growth in real wages compared with earlier decades.

Therefore, although current policy debate is, perhaps understandably, dominated by the ‘cost of living crisis’, what we should really be focusing on is how to generate a long run secular improvement in productivity and real wages. This will not only require greater attention to the hardy perennial of raising business investment (including skills training) in the UK but also a debate on the kind of labour market institutions needed to ensure that workers’ obtain a fair and proper share of any gains in productivity.”