The Bank of England always expected that Britain’s low levels of unemployment would sooner or later see wages start to rise and feed through into rising prices.
But for several months, the labour market appeared to defy gravity, continuing to tighten without any significant effect on wages.
Now the central bank believes it can see hard data that wages are rising and that interest rates will need to move faster than previously expected.
Wage growth lagged behind inflation last year, despite unemployment falling to a 42-year low of 4.3 per cent.
But the last official wage statistics showed the gap narrowing: the annualised rate of growth of pay rose to about 3 per cent in the second half of 2017.
Meanwhile, those changing jobs have in recent months achieved wage rises of a similar level to that witnessed before the financial crisis and employers have reported that they expect pay settlements to average 3.1 per cent in 2018, compared with 2.6 per cent in 2017.
The sharp rise in inflation last year is thought by the bank to have been largely driven by the depreciation of sterling, which increased the cost of imported goods, and rising global oil prices. But even once these effects dissipate over the coming months, the bank expects domestic inflation to take up the baton.
The Monetary Policy Committee assumes in its forecasts that the UK will leave the EU through a “smooth” Brexit. But the committee acknowledged yesterday that the departure “remains the most significant influence on, and source of uncertainty about, the economic outlook”.
Mark Carney, BoE governor, said that the “most important decisions by orders of magnitude that will be taken that will affect UK households’ and businesses’ likely prospects in the years to come”, would be those taken as part of Brexit negotiations rather than by the MPC.
But despite Brexit uncertainties, the BoE is now increasingly confident that pay growth is already picking up in a tight labour market with low unemployment.
The bank has just carried out its annual detailed assessment of the UK’s capacity to produce output. On the basis of this, the MPC concluded that there was no reason to upgrade its forecasts for the future sustainable rate of output growth. There was, it said, no reason yet to think that productivity growth was recovering faster than expected.
“We’ve been making the case for quite some time for an accelerated pick-up [in productivity], but the economy just didn’t co-operate,” Mr Carney quipped yesterday.
The main change in the bank’s latest forecasts from three months ago was an upwards revision to its expectations of the strength of the global economy, which helps Britain’s exporters. The central bank therefore increased its forecast for UK growth for the current year from 1.7 per cent to 1.8 per cent.
This rate of growth, the MPC said, was faster than the 1.5 per cent annual rate that the economy could sustain without generating inflationary pressure.
“As growth in demand outpaces that of supply, a small margin of excess demand emerges by early 2020 and builds thereafter”, prompting persistent upwards pressure on inflation, the committee concluded.
The combination of faster near-term growth, evidence of a pick-up in wage inflation and no change in long-term growth prospects left the MPC no longer willing to accept that it could safely “set policy so that inflation returned to its target over a longer period than two years”, according to Mr Carney.
It was now “appropriate to set monetary policy so that inflation returns sustainably to its target at a more conventional horizon”, which has traditionally been two years.
Although the MPC’s message was more hawkish than previous communications, Mr Carney stressed that interest rates were not likely to rise to the levels common before the financial crisis.
The UK’s official interest rate averaged 5 per cent over the decade between central bank independence and the start of the financial crisis.
But, referring to the interest rate rises that are likely over the next few years, Mr Carney said: “These are interest rate cycles unlike those [the public] have experienced in the past. We’re not talking about going back to those levels.”
In the February meeting, the committee voted unanimously to keep interest rates on hold at 0.5 per cent and not to expand its quantitative easing programme beyond the £435bn of gilts it currently holds. It added that it still thought that any future rate rises should happen “at a gradual pace and to a limited extent”.
Additional reporting by Michael Hunter
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