Wage Inflation and Unemployment in the UK

As a further follow up on the NAIRU discussions mentioned in my last two posts, I have looked at the historical relationship between wage inflation and unemployment in the UK. 

The first of the two graphs below shows annual change in average earnings against unemployment from 1973 to 2016.  The second graph shows the change in the change, what we might think of as the acceleration of wage inflation.  I have divided the points into three periods: 

1973 - 1979: the period before the Thatcher government

1980 - 1991: up to inflation targeting

1992 - 2016: the period of inflation targeting

The trend line covers the whole period.

 A few points are worth making here.

Both charts show quite a wide scatter.  Although both show a vague trend across the whole period, the correlation is not particularly strong in either.

Although the correlation is somewhat weak, the charts suggest that both the level of wage inflation and its acceleration are negatively correlated with unemployment.

There appears to be a somewhat better correlation if we look at the periods individually.  Each individual period generally continues to show the same direction of correlation.  However, the steepness declines over time, both in relation to wage inflation and its acceleration. 

For the period of inflation targeting, there appears to be very little correlation between unemployment and the actual level of wage inflation, whilst there is still a slight correlation with its acceleration.  This is probably the opposite of what I would have expected.

I addition to displaying the steepest relationship, the plot for the 70's also shows the greatest scatter.  This probably reflects various external factors such as the oil price shock and the social contract.

The only really clear conclusion here is that the relationship between these variables is a complex one, but it does appear that there is some connection between unemployment and not only, wage inflation, but also its acceleration.

Unemployment, Vacancies and Wage Inflation

Simon Wren-Lewis's post on the NAIRU (that I discussed in may last post) prompted a lot of interesting comments.  I thought it worth expanding a bit on what I wrote previously.  The chart below shows unemployment and vacancies in the UK.

The obvious thing here is that there is a negative correlation between the two.  Higher vacancies are associated with lower unemployment.

This reflects the level of overall demand in the economy.  Higher demand leads firms wanting to take on more staff and therefore to the creation of more vacancies.  Some of these positions will be filled by the unemployed, reducing their numbers.  Other positions will remain unfilled.

The filling of vacancies does not always come from the ranks of the unemployed.  In some cases, firms will hire by enticing workers to move from other firms (I would guess this is actually the majority of cases, but I don't know where to find data on this).  This process generally requires recruiting firms to offer higher wages.  The more vacancies they need to fill, the more pressure to raise wage offers.  At the same time, other firms may need to raise wages to prevent staff leaving.

The more vacancies there are then, the more wage inflation pressure there is.  And the relationship between vacancies and unemployment is clear.  The much more difficult question is whether this wage inflation pressure gives rise to stable inflation or accelerating inflation.

The NAIRU and Nominal Wage Rigidity

Simon Wren-Lewis has a post discussing the NAIRU.  He acknowledges that it has its problems but struggles to find a good alternative.

The idea with the NAIRU is that, when unemployment falls below that level, we don't simply have a higher rate of inflation, we have an ever increasing rate of inflation.

The theory here is that wage inflation reflects an attempt by workers to secure a particular real wage, based on their expectations of price inflation.  If they are thwarted by price inflation higher than expected they will revise their expectations and increase their demands.

However, whilst wage inflation may sometimes be driven by real wage concerns, it is not clear this should generally the case.  Particularly at lower levels of inflation, changes in aggregate wages may have little to do with real wage considerations.

First of all, it is worth noting that the inflation rate, and the rate of wage inflation, are aggregate figures.  At any time, some firms will be facing supply constraints and will be bidding up wages.  Others will find themselves with excess capacity and will be holding wages constant (or in rare cases, cutting them).  The balance will vary with the level of aggregate demand.  There isn't a single labour market and a single wage.

One of the reasons why the idea of a single wage might be unhelpful is to do with nominal wage rigidity.  On the whole, wages are not subject to constant revision.  An individual worker's wage is fixed when he is first employed and then only changed when there is sufficient reason to do so.  

At low inflation rates, therefore, most wage inflation arises from the turnover in jobs, where some firms are hiring and others are firing.  The lower the level of unemployment, the more that turnover requires hiring firms tempting workers to change jobs, rather than simply drawing on the pool of unemployed.  This requires greater wage differentials.

Actual cuts in nominal wages are unusual.  Having greater wage differentials therefore requires having a higher minimum average level wage inflation when unemployment is lower.  The higher average means the wages that are growing the least are not actually falling.

Real wages play no role in this.  It is all to do with relative wages.  So there's no question of foiled expectations or any reason to think that this inflation should accelerate.

All this means that, at low rates of inflation, we may well have some kind of trade-off between unemployment and inflation, rather than the accelerating inflation dictated by the NAIRU.  However, if higher rates of inflation become the norm, this kind of relationship may break down.  If the average rate of wage inflation is high, then cuts in relative wages can be easily achieved simply by holding some nominal wages fixed for longer.  The pay-off between inflation and unemployment depends on the reluctance to cut nominal wages being relevant.

Furthermore, if it becomes normal to frequently adjust wages to compensate for price inflation, then some measure of indexed wages starts to replace the fixed nominal anchor as the benchmark for relative wage competition.

So, accelerating inflation may still be a trap to fall into.  However, as conceived here, this does not simply arise from venturing past the NAIRU.  It comes from allowing inflation to persist at too high a level and for too long.  It is true that this could come from trying to achieve excessively low unemployment.  But wages are not the only factor in determining price inflation.  Things like exchange rates and world commodity prices also play a role.  On the whole, it should be no surprise that it is difficult for advocates of the NAIRU to pin down what the level of the NAIRU actually is.