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The labour market

employment and unemployment
labour costs

Conditions in the labour market are another important influence on interest rate decisions. They provide information about the balance between demand and supply, and the extent of inflationary pressures in the economy.

Like other markets, conditions in the labour market depend on the demand for labour relative to the available supply - in other words, how many people firms want to employ and how many people are available to work. Firms will tend to demand more workers when wages are lower, and more individuals will be inclined to seek employment when wages are higher. This interaction will determine, in a broad sense, the number of people in employment across the economy as a whole.

Many factors will influence the demand for, and supply of, labour. So it is necessary to keep abreast of all developments in the labour market. An example is the Government's New Deal programme, which aims to reduce unemployment. Month by month, the MPC considers the levels and changes in employment and unemployment, and the rate of increase in wages and other earnings. Teams will need to monitor these data closely.

employment and unemployment        

The numbers of people in work and out of work provide important indications of the level and growth of economic activity, and of the level of pressure on the supply of labour and, in turn, wage increases and prices.

unemployment

The unemployment rate is a key measure of the balance between labour demand and labour supply. It can be thought of as the number of people available and looking for work, expressed as a proportion of the working population.

Unemployment is measured in two main ways - the 'claimant count' measure and the Labour Force Survey (LFS) measure. The claimant count is the number of people eligible for, and claiming, social security payments as a registered unemployed person.

The LFS measure is based on a survey of households and reflects the number of people who are looking for, and available to start, work. They need not be claiming social security benefits, so the LFS measure and the claimant count measure tend to be different.

Claimant count and LFS data are available on a regional basis as well as nationally. This gives the MPC a guide to economic activity and labour market conditions in each region, and helps them to judge the extent to which changes in unemployment are broadly based or concentrated on particular parts of the country.

unemployment and inflation

As we stressed in the Inflation section, there is no permanent trade-off between inflation and output, and the same is true for inflation and unemployment. But, again, there are important trade-offs in the short term. Unemployment will vary with output growth in response to changes in demand. When the unemployment rate is low, firms are likely to find it more difficult to recruit new staff and retain existing staff, who will find it relatively easy to find other jobs. Consequently, firms may need to offer higher wages to attract and retain labour. Low rates of unemployment can be associated with higher inflation and vice versa.

But there is no particular rate of unemployment below which inflation will always tend to rise. It is necessary to monitor all the information available to determine when labour is relatively scarce or relatively abundant, and make judgements about the likely impact on wages and other earnings.

the 'NAIRU'

Economists use a concept called the 'non-accelerating inflation rate of unemployment' - the NAIRU - as a guide to thinking about the relationship between inflation and unemployment. This is similar to the output gap concept discussed in the Inflation Outlook section. But, rather than output reaching a certain level beyond which inflation starts to rise, the idea is that unemployment falls to a level below which inflation starts to rise.

The level of the NAIRU cannot be determined with any precision for the purposes of setting monetary policy. Like the output gap, it is a useful conceptual tool. It is easier to construct plausible estimates after the event - ie once we have observed inflation - rather than in anticipation of it. And the rate of unemployment at which inflation is likely to start rising can vary over time. For example, if unemployment benefits are reduced or the skills of the unemployed are improved, the NAIRU might fall as more people are drawn into employment. Changes in labour market legislation over recent decades, and greater flexibility in employment conditions, such as more part-time working, might have reduced the NAIRU. But the level is a matter of inconclusive debate. Consequently, monitoring wage pressures is especially important.

inactivity

The number of people potentially available to become employed is likely to be greater than the numbers measured as unemployed. Unemployment does not include some groups of people such as those registered sick or other people who are not currently seeking work - for example, retired people or parents who look after young children. These groups are not in employment or measured as unemployed. But they might enter the labour market at some point, perhaps as their own circumstances change or if changes in the labour market make working more attractive or achievable. Some groups are, of course, more likely to enter the labour market than others.

We describe this pool of people as economically 'inactive'. Inactivity is measured as the size of the adult population minus the number employed and unemployed. The number of inactive people is another measure of the pool of people who are potentially employable. The participation of women in the labour market has grown considerably over recent decades. This is one of the reasons why we have seen the growth in employment exceed the fall in unemployment. Another factor is population growth, which will be affected by migration flows in and out of the UK.

So a rise in employment will not necessarily be matched by a fall in unemployment if people are drawn into the labour market from 'inactivity'. It is therefore necessary to look at unemployment and employment separately.

employment

There are also two principal measures of employment in the economy - a measure called 'Workforce Jobs' and the Labour Force Survey (LFS) measure. Workforce Jobs data are obtained from firms. They record the number of jobs so the measure may overstate the number of people employed because some people have more than one job. The data are available both for the whole economy and for individual sectors. Data on the manufacturing sector are published more frequently than other sectors. The LFS data are based on responses from households and measure the number of people employed rather than the number of jobs. Figures are available for both full-time and part-time employment.

employment and output

We would expect changes in employment to be related to changes in firms' output. As firms produce more, they might need to recruit extra people. But the growth in employment is unlikely to match the growth in output, in terms of its timing or extent. Extra output might be produced with relatively more equipment and machinery rather than people, so we might see a larger rise in investment relative to employment. Over time, labour productivity tends to rise - less labour is needed to produce a given amount of output.

Whether employment rises with higher output will also depend on the amount of spare capacity available. If firms are operating with spare capacity, they will be able to produce higher levels of output without necessarily recruiting additional people. More output can be produced with the same number of people. Again the productivity of labour increases.

But even when higher output requires more labour, employment might not initially rise. Increases in output might be gradual. Firms might wait for output to increase by a certain amount before they decide that it is worthwhile employing additional people. Furthermore, firms might be uncertain about whether demand will remain strong and whether the higher level of output will be sustainable. Of course, some firms are able to plan increased production, in which case employment might rise ahead of output. But, generally speaking, employment growth is likely to lag behind growth in output.

hours worked

It is also possible to look at data on the number of hours worked, provided by the Labour Force Survey. This might be more closely related to changes in demand and output than the numbers employed. As demand rises, firms might initially increase overtime working rather than recruit extra people. And if demand falls, firms might be reluctant to reduce the size of their workforce until they are certain about the level of demand. Given the costs of recruitment and redundancy, firms might want to retain staff during periods of lower output growth and instead reduce the number of hours worked. Equally, they might delay recruitment until the need for it is clearly established.

employment intentions, vacancies, skill shortages and recruitment difficulties

In addition to the official statistics, we can also look at survey information on labour market activity, such as that from the British Chambers of Commerce (BCC), Confederation of British Industry (CBI) and Manpower. Business surveys provide information about firms' employment intentions - whether they intend to increase or reduce the number of employees in the future. This might tell us something about labour market activity in the future and about firms' expectations of future demand - if they expect demand to rise or remain at a higher level, firms are more likely to want to recruit extra people.

We can also learn about the extent to which firms are experiencing difficulties filling job vacancies. This might tell us something about the balance between the demand for labour and its supply, and therefore whether there is likely to be upward or downward pressure on wage increases. Firms often have difficulty recruiting people with the right skills for available jobs. Some surveys ask firms whether or not they are experiencing skill shortages. These data can be considered, along with data on the job vacancies, to help build a picture of the demand for labour and the extent of pressures in the labour market.

Key data: employment and unemployment

claimant count
LFS unemployment
inactivity
Workforce Jobs
LFS employment
LFS hours worked

labour costs         

Labour costs - which include wages and non-wage costs such as pensions and national insurance contributions - are a major component of firms' total costs and are an important influence on prices. The actual proportion will vary depending on the activities of each business. For example, in the manufacturing sector, labour costs account for about 40% of total costs. In many parts of the service sector, the proportion is likely to be higher.

If demand for goods and services is rising strongly, firms are likely to need to recruit more employees to increase production. If their extra demand for labour exceeds the supply available, firms may need to increase wages.

Wages are also the main source of income for most people and therefore a key determinant of the amount that they can spend. So the rate of increase in wages provides a good indication of consumer spending in the economy.

wages, unit costs and productivity

Higher wages will be an additional cost to firms. But, even with higher wages, if each employee produces more, ie if productivity is rising, then the cost of producing each unit of output may still fall. And higher wage costs might also be offset by lower costs elsewhere in their business. In short, output might rise more than costs, thereby lowering the unit costs of production.

But if wage increases add to firms' unit costs and demand conditions are favourable, some firms are likely to seek to pass these increases on to customers as higher prices. In this way, higher wages lead to higher inflation.

It is not possible to know what rate of increase in wages will lead to higher or lower inflation. Productivity growth will vary over the course of the economic cycle - output might be rising strongly, lowering unit costs even if wages are rising. Its trend rate of growth may also vary over time, for example, in response to factors such as the increased use of computers and the spread of information technology. But it is difficult to separate the trend from cyclical influences on productivity growth. You can observe the current rate of productivity by looking at the ratio of output to employment, but only informed guesses can be made about the future.

earnings and wage settlements

The main measure of the growth in wages is the Average Earnings Index (AEI). Earnings include basic wages and other earnings such as overtime and bonus payments. We can look at data for total earnings and the contribution made by bonuses and, separately, wage settlements.

Average earnings data are published each month, both in terms of an annual growth rate and a three-month moving average of the annual growth rate. The latter is referred to as 'headline' earnings growth. The growth in average earnings for the whole economy is also broken down by sector - such as manufacturing and services - and by industry. This allows us to compare sectoral earnings data with other sectoral data, such as output and employment, to judge the nature of demand and inflationary pressure across the economy as a whole.

Data on wage settlements are available for both the private and public sectors of the economy. By far the most important months for wage settlements are January and April because this is when most annual adjustments to wage rates are implemented. However, compiling data for these months is often delayed as wage negotiations can take time to conclude.

Changes in the annual growth of earnings in individual months can sometimes reflect a small number of significant wage settlements, such as those for large firms or public sector bodies; and bonus payments which can vary considerably from year to year, both in terms of amount and timing. Individual wage settlements and bonus payments will, of course, reflect specific company circumstances as well as wider labour market conditions. So you need to be careful before drawing conclusions from the data. The 'headline' AEI figures smooth the effect of month to month volatility in earnings growth.

Key data: wages and earnings

Average Earnings Index
headline AEI
wage settlements
productivity
unit wage costs

wage drift

Over the course of the economic cycle, the rate of increase in basic wages relative to total earnings is likely to vary. As demand and output rise, elements of total earnings such as overtime and bonus payments tend to increase more quickly than basic pay. In other words, overtime and bonus payments increase as a proportion of total earnings. The gap between total earnings growth and wage settlements is referred to as wage drift. The extent of wage drift is likely to be affected by the demand for labour. Firms might find that some elements of wage drift, such as overtime payments, are easier to change than basic pay as economic conditions change.

It is also useful to consider the nature of bonus payments. Bonuses paid to staff for good performance or the profitability of a firm over the previous year might tell us more about the past strength of demand in the economy. Bonuses paid to retain staff might tell us more about firms' expectations of continued or rising demand in the future. Of course, it might be difficult to separate these explanations. And, whatever the reason for bonuses, they add to the potential spending power of employees, though some of the money might of course be saved rather than spent.

Overall, earnings are an important part of the MPC's assessment of economic conditions - signalling both the strength of future demand and inflation. Teams should monitor the growth of earnings and their composition as a key input into their overall judgement about the economy and the inflation outlook.

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