What is the relationship between inflation and pay?

With inflation high and set to remain so, some economic commentators have warned that pay pressures from employees could fuel a ‘wage-inflation spiral’ and keep price rises higher for longer than they might be otherwise. It’s been a good while since such a thing could be said to have occurred – the 1970s to be precise. But might we be facing a similar situation today?

To answer this we need to look at some of the assumptions behind the question. With wages coming first in the eponymous equation, many suppose that pay increases are the trigger for inflation. But this is clearly not the case.

The latest official inflation estimates and economists’ forecasts for inflation show that the current generalised rise in prices has its roots in pandemic-produced disruptions of supply chains on the one hand, and higher energy and oil prices on the other.

The other problem with the notion of a ‘wage-price spiral’ is that it also ignores the actual relationship between the two, which is that wage rises always lag behind inflation. The chart below shows this and, inter alia, a weak association between pay and inflation, very clearly. Since the economic crisis of 2009, the median basic pay award has been more or less stuck at between 2 and 2½%. When inflation has risen the median settlement hasn’t followed it upwards, though neither has it followed inflation down when the latter has fallen (which has led some commentators to complain about wages being ‘stickier’ than they should be, another topic entirely).

So ideas about wages somehow causing inflation ignore the wider factors that produce price rises and mischaracterise the real relationship between the two. But higher inflation is a reality. Will pay settlements respond and could this feed into subsequent higher levels of inflation? There are certainly initial indications that pay awards may be reacting to inflation, with the latest median (for the three months to the end of October) up a little while the upper quartile has increased significantly, as has the average, though to a lesser extent. The added factor is of course labour shortages and some employers have boosted basic pay in response to these.

However, another measure of pay movements, the official average weekly earnings (AWE) series, is now on a downward trend. The AWE is indeed showing lower growth than previously, but is still significantly higher than the median basic pay award, reflecting moves employers have made to deal with recruitment or retention problems, such as raising starting salaries and paying signing-on or staying-put bonuses. This is also a quieter time for pay-setting generally, with most annual pay reviews taking place in April (and to a lesser extent, in January).

How might we characterise the labour market? If it’s tight then pay pressures will be greater and vice versa. It’s not yet as tight as it was pre-pandemic, in terms of employment, but the trend here is upwards and it looks to be heading in that direction. Against this, some economists have argued that continued high levels of economic inactivity – where people are neither working nor looking for work – are a source of labour market slack. They could be right, though at the moment this element appears to be contributing to staff shortages rather than acting as a straightforward dampener on competitive wage pressures. In fact, it could be argued that the pandemic as a whole has tipped the balance of market influence somewhat in labour’s favour.

As prices rise under the influence of other factors, employers have reasons to raise their workers’ wages. Real wages had been falling before the current period, and if they fall further in this one then companies will have fewer buyers for their goods and services. Some firms will have scope to offset wage rises by absorbing them in profits, but they are also likely to look for increased productivity in return. That’s another reason to think that concerns about wage rises feeding inflation are probably premature at this stage.