Why the Bank of England with be Wrong Again on Wages

Introduction: Falling Real Wages

Out of all the major measures of economic performance, real wages have been one of the most important measures to have failed to improve over the last few years. The inability of wages to grow in line with prices has meant that despite a strong recovery in output and employment growth, the UK has indeed been faced with a Cost of Living Crisis. This contraction in real wages means that the economic recovery has not led to higher living standards for many families.

Furthermore, the recent overshooting of borrowing targets is incongruous with robust output growth. However, this slowing of deficit reduction can in large part be explained by lower than expected income tax receipts which are themselves a function of negative real wage growth.

Whilst the Bank of England at the beginning of the year expected a return to real wage growth, the Governor of the Bank of England now forecasts that wages will grow in real terms by mid-2015. To examine whether this forecast is reasonable, it is worth examining the average weekly earnings (AWE) data provided by the ONS. The three month average of earnings is used so that single-month distortions can be largely discounted.

AWE over the last year has been particularly poor despite strong economic growth. In July 2014, AWE reached £478, an increase of just 0.6% over the year and well below the 1.6% consumer price inflation in the year to July. This means that AWE are virtually unchanged since May 2013, when they reached £477.

Inflation has been higher than nominal wage growth for every month over the last six years apart from on three occasions (March and April 2010; and March 2014). Over this period, the monthly CPI figure was an average of 3% compared to an average nominal wage growth of just 1.5%.

The Bank of England forecasts that CPI will be 1.86% by the end of Q2 2015 based on market interest rate expectations and no change to the stock of asset purchases. Assuming that the CPI rate in July 2015 is similar, then in order to achieve growth in real terms, AWE therefore need to grow by 1.9% in nominal terms in the year to July 2015.

AWE in May, June and July 2014 were £479, £477 and £478 respectively. This gives an average of £478. If earnings are to have grown in real terms, then the three month average of weekly earnings will need to be £487 by July 2015.

Whilst an increase of £9 in AWE over a year may not seem large, it would still need to be much bigger than earnings growth over previous years. In the year to July 2014, AWE grew by just £3 and over the previous two years, earnings grew by just £7. The question is therefore: how likely is it that AWE will grow from £478 to £487 over the next year?

Tim Knox, Adam Memon - Friday, 24th October, 2014