Markets, consumers and quite possibly the Bank of England may breathe a sigh of relief this week as UK inflation holds steady at 6.7% and UK wage growth shows signs of slowing, albeit marginally.
Markets were fearing another rise in the average earnings index, which measures the change in salaries in the past month.
A rise would suggest UK employees are demanding more compensation for their work. However, the Office for National Statistics (ONS) said on Tuesday that average total pay rose 8.1% in August, down from 8.5% the previous month.
Despite that, average wage growth is still close to record highs in the UK. So while data this week might suggest the BoE hold its rate-hike lever steady, wage pressure continues to stand in the face of its commitment to bring inflation down to its 2% target. So why all the fuss about wage growth?
In theory, a rise in earnings is a good sign as it gives a picture of a healthy and growing economy. However, in the present inflationary environment, higher wages only serve to add more fuel to the “inflation” fire.
A rise in wages is one of the primary drivers of domestic inflation, because it puts more money in people’s pockets.
This then increases spending on goods and services, even if the rise in wages is in some way meant to offset the higher cost of living. With the BoE already struggling to keep inflation under control, rising wages is likely to make rate setters feel more concerned than they already are.
In addition to the ONS earnings index, the UK’s Consumer Price Index (CPI) has also been closely examined this week. The data shows that prices of goods and services rose by 0.5% in September compared with the previous month, with no change to the yearly CPI rate.
In other words, CPI failed to dip below 6.7% in the 12 months to September 2023, something markets had not anticipated.
This puts further pressure on the BoE to act forcefully to slow consumer spending, further increasing the odds of a rate hike at the Bank’s next meeting on November 2. A rise in CPI is normal after a recession — even if it is an uncharacteristically short one as during the early stages of the pandemic.
As consumers start to spend more, prices go up. The issue arises when this cycle picks up too much speed, at which point prices rise exponentially and the economy starts to overheat. Even more concerning is when this happens alongside a drop in growth and consumer spending.
This is where we are now, and unfortunately, if workers continue to demand more compensation for their work, it is going to be much harder to get out of this situation without risking a recession.
Earlier this week, markets were pricing in a 73% chance of the BoE leaving rates unchanged. Despite the stronger-than-expected inflation reading and the drop in wage growth, that percentage has shifted higher to 77%, highlighting the fact markets believe wages play a significant part in the BoE’s decision making.
Money markets are currently pricing in one more 25 bps hike between now and March next year, with the first rate cut expected from September onwards. Unfortunately, the BoE has been lagging other central banks when it comes to controlling inflation and the recent data highlights the struggles we continue to face tackling price rises.
If we compare the situation in the UK with that of the US or the EU, our economy is at greater risk of stagflation — a situation where inflation remains high but growth stagnates. This would put further strain on consumers and households, increasing the risk of recession, which would likely be accompanied by rate cuts.
These measures may seem contradictory, because cutting rates is usually an attempt to increase spending, but if inflation remains sticky it could worsen the situation. This would not be a good situation for UK consumers as they would have to endure higher prices for longer — even as their spending capacity drops.
The BoE has a challenging road ahead and while much of their decision-making will likely be data-dependent, there is also the fragile act of balancing inflation-targeting measures with growth measures. We are not out of the woods yet.
