How wage inflation has been tamed

News Analysis: Two factors - the New Deal work scheme and low price rises - have helped to draw the sting from pay expectations

EIGHT MONTHS ago the Bank of England was so concerned about inflationary pressures in the labour market that it hiked UK interest rates up to 7.5 per cent. Unemployment was unsustainably low, the Bank said, and would have to rise in order to keep inflation in check.

Since that shock rate rise last June, unemployment has fallen further and employment has risen. Official figures out tomorrow are expected to show unemployment staying close to 20-year lows. Despite this, the Bank felt comfortable cutting interest rates half a point to 5.5 per cent this month and leaving the door open for further cuts in last week's quarterly inflation report. So why isn't the Bank worried about wage inflation any more?

Part of the answer is that deflationary pressures from other sources - falling factory gate and commodity prices - have outweighed concerns about inflationary pressures in the labour market. Another is that some information the Bank based its decision on in June - the official average earnings index - turned out to be questionable. In particular, the worryingly sharp rise in earnings in the first half of the year was revised away in the autumn when the Office for National Statistics issued new numbers.

A third reason for the Bank's apparent lack of concern about developments in the labour market is that unemployment is a so-called "lagging" indicator - it takes time for a drop in growth to impact on jobs. So, although the backward-looking official data may still be painting an upbeat picture, things may not stay rosy in coming months.

Indeed, all the forward-looking studies of employment intentions - such as the British Chambers of Commerce survey - suggest that unemployment will rise in the next 12 months. "The fact that we haven't seen an increase in unemployment so far shouldn't make people too sanguine," said John Philpott, director of the Employment Policy Institute. And, although official earnings data have been suspended in the wake of the confusion over the revisions, surveys suggest that wage inflation may be moderating as employers tighten belts and prepare for tough times ahead. Analysts at Goldman Sachs say: "On the partial information available, there appears to have been a stabilisation in pay deals in 1999 at around the 4 per cent level recorded last year."

A growing body of economists, however, believe there is a fourth, perhaps more significant, reason for the dwindling concerns about developments in the labour market. In recent months there have been tentative signs of fundamental changes in the jobs market that may mean the UK is less prone to periods of high wage inflation and high unemployment than it has been.

In particular, there has been evidence both of the positive impact of the Government's New Deal and of a change in expectations about future inflation - a key determinant of wage increases.

Take the New Deal first. Although it is early days for the government's scheme, the initial signs are encouraging. The Employment Policy Institute's regular survey of employment trends - the latest issue of which is published tomorrow - finds that unemployment has "undoubtedly been affected by various government initiatives". Dr Philpott noted that the number of long-term unemployed in the 18 to 21 age group - a group specifically targeted by the New Deal - fell by 25 per cent between January and October last year. Data on inactivity is also encouraging. There has been a steady decline in the rate of inactivity - that is, the proportion of people who do not want a job.

Although it is difficult to disentangle the impact of government initiatives on the labour markets from other factors, most experts seem agreed that initial indications are good. According to Dr Philpott, government initiatives should "increase the effectiveness" of the UK's labour pool. He said: "That means there is less likelihood of inflationary pressures in the labour market. Assuming government policy continues to move in the right direction, we should see the sustainable rate of unemployment fall."

Falling inflation expectations also indicate that there may have been structural shifts in the UK labour market. Expectations about low inflation tomorrow tend to mean lower levels of wage inflation today. Employees are more likely to accept low wage increases if they believe the cost of living has stabilised.

So why have inflation expectations fallen? This is in large part due to the decision to grant the Bank of England independence. People have doubts about the ability of politicians to stick to tight inflation targets, but the independent Monetary Policy Committee has established itself in most people's minds as being a tough inflation fighter. Another factor may be the growing belief that the UK will join European monetary union - Europe's inflation track record has been better.

Looking ahead, however, things may become a little more difficult. British business, quite understandably, is concerned about the administrative burden of new measures such as the Working Families Tax Credit and the European Working Time Directive. There are also worries that the National Minimum Wage - although perhaps desirable on social grounds - may undermine labour market flexibility. So far, government reforms, both of incentives to work and in monetary policy, do seem to have had a positive impact in the jobs market. The challenge now is to keep the momentum going.