The strong labour market has been the main driver of recent economic performance
The labour market has had a major influence on UK economic performance in recent years with increasing levels of employment supporting growth in consumer spending. This has been despite the rate of wage growth lagging behind what we would have expected based on historic relationships between the levels of unemployment and pay. The UK economy has grown even though productivity performance has also disappointed.
Looking forward, Brexit, technological developments, changing demographics and Government policy in areas such as the “gig” economy could all potentially disrupt the UK labour market and change the environment for businesses. This latest EY ITEM Club special report on the UK labour market is therefore particularly timely, providing an in-depth analysis of the current situation and the factors that will influence the future structure and size of the employment market.
Signs of a slowing jobs market…
The rate of joblessness in the UK, measured by the Labour Force Survey (LFS) of 4.7% in February 2017 is the lowest since 2005 and at a level only rarely achieved in the last 40 years. However, the rate of improvement in the labour market is slowing. In the last quarter of 2016 the increase of 1% was only half the rate of the previous year; and the growth in people in work of 30,000 in the 6 months to February 2017 was the smallest rise in any 6 month period for almost 4 years.
…and no signs of a significant uptick in pay…
The failure of pay growth to accelerate in recent years in the light of falling unemployment has been hard to explain. Pay increases have stubbornly remained anchored between 2 to 3% for the majority of the period since 2010. In September 2005 when unemployment was at similar levels, average earnings were increasing by almost 5% year-on-year. And there appears little prospect of change. According to the Bank of England’s regional agents, pay settlements in the early part of the year (an important period for many firms in the pay calendar) have been clustered around 2 to 2½%.
…leave us working to understand what is driving the market…
The EY ITEM Club identifies a number of possible reasons for the change in the relationship between levels of unemployment and pay:
- Lower productivity may have played a part as real wage growth and productivity improvements have historically gone hand-in-hand;
- A decline in the “equilibrium” unemployment rate as a result of increasing labour market flexibility and the growth of self-employment;
- Increased slack in the labour market with more than twice the number of officially unemployed people wanting more work;
- Growth in labour supply due to a higher number of older people in the workforce and increased migration;
- The impact of austerity reducing public sector pay; and
- Shifts in the sector mix and the composition of employment, such as a decline in higher paid jobs.
It is clear that there is no simple explanation for the changing nature of the UK labour market. This means that businesses cannot assume that the current conditions will continue into the future, especially as other potentially very disruptive factors may come into play.
…and how market conditions will evolve in future…
As the recent EY ITEM Club Spring forecast showed, the UK economy is starting to slow and this will lead to a reduced demand for workers, with EY ITEM Club forecasting growth of 0.6% in 2017 and 0.1% in 2018 compared to 1.4% in 2016. This fall in demand is likely to be matched by a fall in supply as the rate of growth in older workers slows and migration levels reduce, even before Brexit, reflecting changes in the relative economic performance of the UK and EU as shown below.
EU migration into the UK has been influenced by relatively higher economic growth and hence employment growth in the UK compared to the EU. The EY ITEM Club forecasts that a narrowing of the economic differences between the two economies will lead to a fall in migration. This is before the impact of the uncertainty that Brexit will create for migrants thinking of coming to the UK and then the potential post-Brexit restrictions on movement of labour into the UK.
Similar levels of uncertainty surround the impact of technology on the demand for labour, with a wide range of views on both the potential level of change that it will result in and on the time period over which this will occur. The EY ITEM Club cites two studies which suggest the number of jobs at risk ranges from 9% of the total to 47%, illustrating the degree of uncertainty.
Taking the demand and supply side factors into account, unemployment is forecast to edge upwards, reaching 5.8% on the LFS measure in 2019. However, there is potential for variances either up or down around this number given the issues identified above.
…with pay levels especially hard to predict…
The EY ITEM Club expects that pay growth will struggle in the face of headwinds, including the structural developments highlighted earlier and the persistence of low public sector pay awards. In addition, the extra costs faced by employers arising from April’s introduction of the apprenticeship levy and the levying of NICs on termination payments, along with the ongoing expansion of pensions auto-enrolment, are likely to be at least partly passed through to workers, depressing pay growth. The OBR estimates that the apprenticeship levy and auto-enrolment will reduce average earnings by 0.7% by 2020-21.
 Office for Budget Responsibility, ‘Economic and fiscal outlook’, November 2016. http://cdn.budgetresponsibility.org.uk/Nov2016EFO.pdf
In practice, given how unresponsive earnings have been to an unemployment rate which is only marginally above the Bank’s estimate of a 4.5% equilibrium, there seems a compelling case that the equilibrium rate is lower. Hence, the prospect of an uptick in unemployment, partially reversing the fall in joblessness towards its equilibrium level, risks pushing pay growth down.
This would certainly be consistent with the trend that has been evident for several decades. Since the 1970s, pay growth has fallen during periods of economic weakness. But the trend over subsequent recoveries has been one of broad stabilisation rather than a rise back to the pre-recession norm. Since the end of 2009, average earnings have risen by only 1.9% per year. So the 30-year downward trend in earnings growth and the inability of lower joblessness in recent recoveries to lift growth back to pre-recession norms presents two more reasons to think that the current softness of pay growth may persist.
…and so close attention to market developments is essential.
The labour market has surprised most observers in recent years so there may well be more surprises to come. Businesses certainly need to monitor developments in employment levels and pay at the macro level to identify potential shifts in the market and to use this to drive deeper analysis of the implications for their businesses.
Key areas to focus on are:
- Assessing the future demand for labour across the business covering roles and skills and identifying potential areas that could be impacted by changes in labour supply especially due to Brexit, such as a reduction in skilled workers in specific areas currently sourced from EU countries, and developing contingency plans.
- Monitoring developments in pay for specific roles and skills to ensure that reward levels remain competitive and to identify potential risks to margins from pockets of wage inflation.
- Evaluating the case for investing more in skills development and training to improve the contribution of the existing workforce, encourage retention and potentially address emerging labour supply gaps and wage pressures.
- Continuing to review the potential of technology to reshape the workforce across the business.
- Tracking the progress of the Taylor Report on employment which may have significant implications for the classification of employees and hence the economics of certain segments of the labour market.