A new theme to the upcoming earnings season
Labour market tightness is currently one of the most important subjects for the Bank of England (“BoE”). Headline and core inflation in the UK are the highest in the G7, and while hot labour markets are a global issue, the problem seems to be more acute in the UK than in other countries judging by wage inflation numbers. Yesterday we received the Monthly Labour Market Overview which, along with next week’s CPI release, is likely to be the most important input in the BoE’s next monetary policy moves.
Although the labour market in the UK remains excruciatingly tight by most measures, there are some signs that we may be past the worst. We would characterise these improvements as moving from “extremely hot” to “very hot”, which in turn means that the BoE is not yet at a point where they can comfortably pause their hiking cycle. At the same time, and considering that labour market data tends to move slowly and with considerable lags, identifying turning points becomes very relevant.
The first point to highlight is that the supply of workers is gradually increasing. This has to do with the ‘Inactivity Rate’ which accounts for those people who do not have a job and are not looking for one, and are therefore not part of the labour force. Compared to February 2020 the number of inactive people aged between 16 and 64 in the UK has increased by 281,000; however, a year ago this number was close to 650,000 people and has steadily declined since then with last month’s data showing one of the steepest monthly declines. The vast majority of the change since February 2020 is accounted for by those in the “Long-Term Sick” category. Contrary to popular belief, the “Retired” bucket has actually decreased marginally since pre-Covid. We note that the “Long-Term Sick” category is showing signs of plateauing but at high levels. Overall the Inactivity Rate of those aged between 16 and 64 has declined from a peak of 21.7% a few months ago to 20.8%. Although we are not yet at 20.2% of February 2020, it is fair to say the trends are encouraging. In other words, there has been an increase in the supply of workers due to some of them coming back online in the last few months.
Secondly, the demand for workers seems to be easing at the margin. The number of vacancies continues to fall and the ratio of unemployed people per vacancy is increasing. We are still far away from pre-Covid numbers but the number of vacancies has declined every month since May 2022 and the ratio of unemployed people per vacancy found a low in August 2022. The unemployment rate went up in May as the increase in the labour force brought about by a decline in inactivity was not absorbed by higher employment; paradoxically this is good news for the BoE.
So if supply increases at the margin and demand seems to be cooling off, then what about prices in this market? Wages are certainly the missing part in the adjustment towards pre-Covid labour market equilibrium. Compared to May 2022, Average Weekly Earnings increased by 7.4%. If we look at the private sector in isolation the figure climbs to 7.7%. These are significantly higher than what the BoE would feel comfortable with. In order for the BoE to pause and eventually cut rates there needs to be a marked downward trend in wage growth and we are not seeing that yet. In fact, we believe it is hard to unequivocally call the peak yet in wage inflation. More data is required but it is fair to say that both supply and demand dynamics point towards moderation in wage inflation in coming months.
The big question however, is where will wage inflation (and headline and core CPI inflation) settle in the end. The “Long-Term Sick” category has only showed nascent signs of stabilisation at very high levels in the last few months. This is a puzzling dynamic. Speedier waiting lists at the NHS might help but even if this happened it’s unclear if it would solve the problem. Additionally, migration trends have changed since Brexit, the number of EU nationals aged 16 and over who are in employment has moved sideways since 2016 after growing at close to a 9% annualised rate in the preceding decade. Although non-EU nationals migration has continued to increase, the overall trend of non-UK nationals employment is still lower than what would have been otherwise. Importantly, it is not obvious that EU and non-EU migrants come to the UK to perform the same kinds of jobs. Also numbers show that inactivity rates (excluding students) by non-EU nationals are twice as high as those of EU nationals. These are big changes and as mentioned above, labour market data tends to move painfully slowly.
In conclusion, the UK’s labour market is showing signs of easing at the margin. While, there is still an imbalance between too much demand and too little supply, both seem to be moving in the right direction; which should mean less wage pressure in the not so distant future. In the medium term, the way in which the new equilibrium is found (i.e. to what extent the supply of workers returns to pre-Covid levels vs a more painful demand adjustment) will be a very important factor in determining what the terminal rate of this cycle and the longer term neutral rate are. But first things first.