Wages are rising rapidly – what does this mean?

Wages have risen by 7.8 per cent in the second quarter of the year, as Sean O’Grady explains why it’s happening and what the fallout will mean for Rishi Sunak

Supply and demand is driving higher wages (PA)

The headline news is that average – there are plenty of variations – pay rose by 7.8 per cent in the second quarter of the year, as compared with the same period last year. This is very high by recent historical standards, and the fastest rate of increase since similar records began in 2001. Pay rates going up at near double figures is something many presumed had been left in the distant past.

The figures suggest that the labour market remains very tight, which has good and bad economic and political consequences for the government. The monthly annual inflation figure is published imminently and will give a further indication about the state of the economy. All those readings will be critical in the Bank of England’s next interest rate decision, due next month.

Why are wages rising so rapidly?

Supply and demand. Because a combination of Brexit and the pandemic reduced the supply of labour so much, and because the economy has at last returned to pre-Covid levels of output, demand for labour – everyone from surgeons to fruit pickers – is in short supply. So employers bid up wages. A few of those who left the active labour market may have been tempted back by higher pay rates (and the squeeze on household budgets), there are still many obvious shortages of all types of workers.

In such circumstances, central banks and governments fret about inflation being driven higher by wage costs, and they then try to reduce the demand for labour by reducing the overall demand for goods and services in the economy. This is achieved by taking spending power out via higher mortgage bills, supported by relatively punitive taxation. For the public sector resistance to lay demands, it means strikes. Hence the state we’re in right now.

Are wages going to catch up with inflation at last?

We’ll learn shortly, but the broad trend is in one sense encouraging – wages up, inflation down. So in the short run, the squeeze on living standards will ease, and many people may well feel better off. However, it’s also true that those in the private sector are enjoying slightly higher wages rises than those in the public sector, and groups such as teachers, nurses and doctors have seen a long-term erosion in the purchasing power of their pay under the long years of austerity in the 2010s. It’s also fair to reflect that many essentials have gone up in price by more than inflation, which hits the less well-off harder. Even those on better wages don’t get pay rises in line with price rises.

On the other hand – all economists are equipped with at least two hands - the rise in wages also points to “domestic” or “core” inflation becoming entrenched in the dreaded wage-price spiral in the longer term.

So in the short run – until say the turn of the year – inflation will come down quite quickly as last year’s hikes in food and energy costs (driven by the war in Ukraine) drop out of the calculations (ie they haven’t doubled again this year, and some have subsided). There will be a bit of a feel-good factor but also muted in the longer term if the Bank keeps pushing interest rates up and unemployment edges higher.

So is this good or bad news for Rishi Sunak?

If inflation falls by as much as some economists predict - down from 7.9 per cent in the year to June, to between 6.7 and 7 per cent for July, it will make for excellent headlines. Thus, the prime minister’s promise to halve inflation over 2023 and get it down to about 5 per cent now looks highly probable. You may expect Sunak and his team to make the most of that, especially given the mess that “small boats week” turned out to be.

Even so, because of still rapid wage growth, mostly unsupported by any improvement in productivity, inflation may take much longer to get from 5 per cent to the actual official Bank of England target of 2 per cent – not until early 2025, according to the Bank. That will still require relatively high interest rates for some time, but a headache for the next government.

Will mortgage bills go up again?

For those on variable rates or applying for a new loan or a remortgage, then yes – and businesses face higher financing costs. To get inflation anywhere near the 2 per cent target will require some real pain over 2024, although rather unevenly distributed – older and wealthier folk with large savings and no mortgages will be happiest.

The bank rate is expected to peak at 6 per cent, but if core inflation – with volatile items such as food and fuel stripped out, and driven by wages – stays persistently high, rates will rise behind that, gradually but inexorably.

Are the pensioners going to get another bumper increase?

Yes, because the “triple lock”, a Liberal Democrat idea implemented by the coalition government a decade ago, guarantees that the state pension will rise by either 2.5 per cent, by inflation, or by the rate of wage increases – whichever is the highest. Despite being suspended during the crazy economic circumstances around the pandemic, the pledge has been honoured and has restored at least some of the reduction in the real value of the pension after the Thatcher government abandoned it in 1980. It has thus played a part in reducing pensioner poverty, and it will go up again in line with wages, ensuring that poorer pensioners don’t get left behind as has happened in the past.

The triple lock will remain in the short time left before the general election, but what happens after that point is extremely sensitive politically. Will the major parties commit to retaining the policy, downgrade it, or abandon it, blaming the poor state of the public finances? The grey vote, which turns out in large and impressive force on polling day, is a powerful one, particularly for the Conservatives.

Economic trends almost always drive the vote, and the way the cross currents of wages, prices and interest rates play out over the next few months for pensioners, private sector wage earners, public sector workers, first-time buyers and business people will no doubt prove crucial.