More than two years ago, I warned about the possibility of wage-price spiral in the U.K. My assessment back then was that inflation in the U.K. might remain sticky because of the combination of various shocks the economy was facing, some of them global but others like Brexit unique to the British economy. Workers would therefore ask for increasingly higher compensation to not fall behind.
Well, it turns out that I was right. The UK has the worst inflation problem and highest wage growth across advanced economies even as the labor market has shifted from good to bad.
This piece will outline the various economic policies and macroeconomic shocks that got us into this mess and provide an outlook for the near future.
Problem 1: Global shocks, from climate change to wars and trade disruptions
The world has become a more volatile place since the Covid pandemic began. Supply chain disruptions have become more common. Wars in Ukraine and the Middle East have led to higher commodity and food prices. Global shipping costs are rising rapidly.
Climate change has accelerated. Global temperature anomalies have risen from about half a degree Celsius in the 1990s to more than one degree more recently. Prolonged heat waves have intensified droughts around the world, disrupting agricultural production not just in warmer climates but even in England. Food prices have therefore risen much faster than overall inflation, putting upward pressure on wages and prices around the globe.
Problem 2: Brexit
Yes, everybody in the U.K. is tired of this topic. People want to move on! But it’s worth repeating that Brexit did permanent damage to the British economy, reducing the living standards of British households by an estimated 5% or more. The pound depreciated by about 15% following the Brexit vote and never really recovered. Trade with the EU has become more costly and cumbersome, especially for small businesses. Corporate investment in the U.K. has stagnated because companies would rather invest in the larger market — the EU — instead of the smaller market that faces all kinds of barriers. Brexit has not just reduced growth, but it also increased inflationary pressures by pushing up import prices and increasing trade costs.
Problem 3: The minimum wage and the NIC hike
In retrospect, Labour’s first Budget turned out to be quite disastrous. After promising not to tax households, they decided to tax businesses instead. The increase in the National Insurance Contribution (NIC) paired with the minimum wage hike led to a substantial surge in employment costs amidst a stagnant economy. Many companies in low-margin sectors had no choice other than to reduce hiring and cut headcount. Payroll employment has fallen by an estimated 140,000 jobs since last fall.
Additionally, corporations that endured the margin squeeze have also passed some of the costs on to the consumer. According to the Bank of England (BOE), the NIC and minimum wage hikes have been a contributing factor in this year’s inflation surge back to 4%. Businesses hiked prices to recover some of their losses.
The minimum wage increase has contributed to elevated wage growth in the U.K., feeding back into service price inflation. The 2024 Budget was not just poison for the labor market but also increased inflationary pressures.
Problem 4: Labor market imbalance
Following Brexit, the U.K. continues to suffer from a severe labor market imbalance that probably won’t be resolved any time soon. The combination of weak growth, high interest rates, and AI have led to a hiring recession in the white-collar space. Demand for workers in tech, consulting, and finance — many “desktop jobs,” if you will — has declined significantly.
Meanwhile, skilled manual workers are in very short supply. In retrospect, pushing so many young people to university instead of trade school might have been a mistake. After decades of underinvesting, many European governments including the U.K. are ramping up defense and infrastructure spending. Skilled manual workers are now missing across various occupations just as the demand for these skills is projected to increase rapidly: from construction crews to lay train tracks and build highways to specialist engineers and technicians assembling submarines, helicopters, and drones. At the same time, electricians, welders, and renewable-energy installers will be needed for wind and solar farms, while nuclear power plants will require operators and mechanical engineers.
The worker shortages across most of these occupations will push up wage growth in the coming years. While the UK government’s plan to expand technical colleges is a step in the right direction, the scale of its ambition falls short of what’s needed to truly solve the skills crisis.
Problem 5: Easy monetary policy
No discussion of inflation is complete without addressing monetary policy. In the end, high inflation is always the result of overall demand in the economy being too high relative to supply — and that means that monetary policy is too easy.
When energy or food prices surged during Covid, central banks temporarily accepted higher inflation because they didn’t want to derail a fragile recovery with interest rate hikes.
Well, it turns out that the recovery was much stronger than initially assumed — and inflation has remained extremely sticky ever since. Nominal GDP, which measures the total size of the economy in pounds, has grown at a rate of more than 5% in recent years. Meanwhile, the U.K.’s supply side has been hammered by Brexit and other structural problems — the housing market, the tax and welfare system, etc. Because the economy’s natural speed limit could be as low as 1.5% according to BoE governor Andrew Bailey, a 5% growth rate in nominal spending implies about 3.5% inflation.
Monetary policy makers therefore need to bring down total spending in the economy to slow price pressures. The main reason they have refrained from doing so is because it would cause even more job losses in an already fragile market. Allowing inflation to be permanently elevated, though, will also be damaging in the long-run.
Problem 6: Wage expectations
With sticky inflation, workers have started to demand significantly higher pay growth in recent years — even in a weaker labor market. Inflated wage expectations and rising inflation expectations have created a negative feedback loop. The wage-price spiral I warned about has turned into permanent headache for the Bank of England. Monetary policy makers might have to allow some further weakening of the labor market to “break inflation’s neck.”
Where does that mean for recruiters?
The latest inflation figures showed a little relief. Projections are for inflation to hit target again, but only by 2027. Wage growth is weakening too, albeit slowly.
For now, recruiters will continue to face higher wage growth demands than before the pandemic. This will be particularly true for skilled manual work since those labor shortages are the most acute. While forecasts are encouraging, there are significant upside risks to inflation, ranging from climate events, supply chain disruptions, and damaged trade relationships to even outright wars. All these risks feed back into wage demands as workers aim to maintain their living standards (and who could blame them?!), threatening to stoke more inflation in the coming years.
