In recent months, annual underlying nominal pay growth has remained somewhat above its pre-pandemic rate, at around 4%–4½%.
Different methodologies can be used to estimate the drivers of pay growth. A standard approach used by economists is to decompose wage growth into three main factors: labour market slack; productivity growth; and inflation expectations.
The size of the contributions from each of these factors can be obtained using a simple linear regression. If prevailing pay growth is higher or lower than explained by these factors, this is captured by an ‘unexplained’ residual component in this model.
Chart A: Pay growth picked up above what can be explained by its usual drivers in 2021
- Sources: ONS and Bank calculations.
- (a) Wage equation based on Yellen (2017). Inflation expectations are based on the Barclays Basix Index and the Citi one year ahead measure of household inflation expectations. Slack is based on the MPC’s estimate of the unemployment gap. Productivity growth is based on long-run market sector productivity growth per head. The unexplained component is the residual. The diamond shows the Bank staff projection for 2021 Q4.
- (b) Bank staff estimates of private sector regular pay adjusted for furlough and compositional effects.
During 2021, underlying pay growth picked up sharply. The pickup was largely driven by a fall in labour market slack (Chart A), as the unemployment rate declined.
For much of 2021, underlying pay growth picked up above rates that could be explained by its main drivers. This is shown in the aqua bars (labelled ‘Unexplained’) in Chart A.
One possible explanation of this additional pay growth is a greater tightening in labour market conditions than captured by this simple model. This may reflect the temporary effects of the furlough scheme, which ended in September 2021.
It may also reflect an exacerbation of typical labour market frictions such as a mismatch between job seekers and vacancies. As the economy reopened, firms posted record numbers of vacancies. As firms struggled to find suitable workers to match vacancies, despite a fall in the unemployment rate, this may have led them to increase wages on offer to attract job seekers.
In 2021 Q4, Bank staff estimate that the ‘unexplained’ component in this model had largely dissipated, which may suggest that some of these frictions had abated.
Looking ahead, the outlook for wage growth will depend on how labour market slack, productivity growth and inflation evolve. Underlying pay growth is expected to pick up to just under 5% in 2022 as the labour market remains tight and inflation increases in the near term.
This post was prepared with the help of Aakash Mankodi, Harvey Daniell and Joshua Perers-Cook.
This analysis was previously published in the Monetary Policy Report in February 2022.
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