Are wages keeping up with the cost of living?

There is currently much debate about whether pay should keep pace with either productivity or inflation. How we measure price growth has a big influence on what we observe, shedding light on how different parts of the economy are performing.

Government ministers – who last year were heralding the arrival of a high-wage economy – are now urging wage restraint. Their reason is that attempts to keep pay in line with inflation may stoke further ‘cost-push’ inflation – the process by which firms pass on the higher costs of producing goods and services in the form of increased prices.

Indeed, talking about pay rises, the prime minister Boris Johnson stated that ‘we are constrained in what we can do not just by the fiscal position – the risk of borrowing too much – but by the risk that we will fan the flames of further price increases […] we cannot fix the increase in the cost of living just by increasing wages to match the surge in prices. I think it is naturally a good thing for wages to go up naturally, as skills and productivity increase’ (GOV.UK).

But are productivity growth and wage growth incompatible with high inflation? And what exactly do we mean by inflation?

Most economists wouldn’t baulk at the idea that wages can grow in line with productivity. If the economy is more efficient, that is usually reflected in growth in pay. Everyone shares the gains.

Standard economic textbooks link productivity to wages net of the level of prices. This link should hold regardless of the rate of inflation since what matters are the real rates of productivity and wage growth – the rate of growth minus the rate of inflation.

Productivity – or, more strictly, labour productivity – is measured by dividing the total value of output of goods and services produced minus the value of inputs (known as gross value added or GVA) in the UK by total hours worked. This calculation also takes into account (or ‘nets out’) the prices of these goods and services.

Think of an economy with a yearly inflation rate of 2% and nominal productivity growth over the year of 5%. The real rate of productivity growth in this case is 3% (the 5% growth in productivity less the 2% inflation rate). Such an economy would allow a real wage rise of 3%, if wages went up in line with productivity.

Equally, an economy could have an inflation rate of 5% and nominal productivity growth of 8%, which would also allow real wage rises of 3% (8% minus 5%), or even inflation at 10% and nominal productivity growth of 13%. Real wage growth is the same in each case.

Of course, these calculations assume that inflation does nothing to harm the growth of productivity or the wider economy. Yet there is quite of lot of evidence that higher rates of inflation might reduce people’s ability to buy things, particularly if they are on fixed incomes (usually the less well off). Higher inflation may also deplete people’s savings (usually among wealthier people, who tend to have more savings) and even hamper government finances (since debt payments are often linked to the rate of inflation).

The process of netting out prices, rather confusingly, is called deflation. A deflator is just a number used by economists to re-scale another number – in this case to convert the headline (nominal) growth in wages into a ‘real’, inflation-adjusted value.

Deciding which prices to use as a deflator is not straightforward and depends on which economic issues are being looked at. The Office for National Statistics (ONS) produces a vast array of indices that are used to measure the change in different types of prices (an index is not a specific price, rather a way of capturing the relative movements in prices over time). Which to use is a matter of fine judgement.

The current debate about inflation and the cost of living is focused on the rate of change of consumer prices and what wages can buy net of consumer price inflation. This is referred to by economists as ‘the real consumption wage’.

It should also be noted that these prices are not the prices that are important to firms. What matters to businesses are the costs of inputs, the prices at which they can sell goods and services, and the wages they pay their workers relative to these prices (the real product wage).

As a result, different prices matter for different aspects of the economy. As such, we shouldn’t be too surprised if these prices do not all move together or change at same rate over time, since they are influenced by different things.

But it does mean that using different prices to deflate (re-scale) wages will give different results. Used well, they can convey various sets of important information about how well or how badly various parts of the economy are doing. Used less well they can be confusing.

Figure 1 shows the percentage growth of several UK-wide price indices since 2007. The prices of materials used to make things have clearly gone up most over time (producer inputs), followed by the prices charged by manufacturers for goods (producer outputs).

The rate of change of prices is next – the consumer prices index including owner occupiers' housing costs (CPIH) is one measure of consumer prices. This is closely followed by the prices of goods and services in the whole economy (GVA) and then the prices charged by producers for services (services outputs).

Figure 1: Price growth since 2007

Source: ONS

How much does this matter for the calculation of real wages (wage growth minus inflation)? Just to make things even more complicated, there is no single source of wage information for the UK economy.

Figure 2 makes use of the average weekly earnings series – the most up to date and high frequency source of earnings data. This is based on a 7% sample of all firms registered for VAT or PAYE in Great Britain (the prices series are all UK-based).

Firms are asked about their total pay bill and the number of employees in the workplace. Dividing the former by the latter gives the average (mean) weekly earnings. Unlike the median calculation (the wages of the people in the middle), the mean calculation can be affected by people with very high pay at the firm relative to others. Regardless of its merits as a measure, the main aim here is to understand whether a given indicator of pay is sensitive to different deflators (price indices) when calculating real wages.

Figure 2 shows the yearly percentage change in real average wages based on different price deflators alongside the growth in (real) productivity. Before the pandemic, the choice of price deflator didn’t make much difference to the estimate of real wages. The prices of producer inputs were growing a little faster than other prices, which made the cost of labour a little cheaper, but not by much. Average real wages were also growing broadly in line with productivity.

The pandemic made the estimates of wages, output, hours worked and prices more complicated. The number of hours that people were working dropped, many were furloughed and sample responses to surveys/data collection fell.

These factors combine to make comparisons over the past year very difficult. By 2022, they are beginning to work out of the system and the estimates, but caution is still advisable. That said, the arrival of near double-digit inflation this year appears to coincide with a large deviation in the price signals coming from different sectors of the economy.

As a result, the real wage estimates based on different deflators have diverged widely. Applying the same deflator used to estimate productivity growth (the GVA deflator), real wages are growing by 3%. Using one measure of retail prices (CPIH), real wages are falling by around 2%. Deflating by the price of services, real (product) wages are constant. Using the price of producer outputs, they are falling by around 8%; and deflating by the prices of inputs to the production process, real wages are falling by around 15%.

Figure 2: Productivity and real wage growth using different price deflators

Source: ONS

What can we conclude from this? In short, we should never take a single figure too seriously – they are estimates after all. But used carefully, we can say something about the trends and their implications for different parts of the economy.

The costs of some inputs into the production process are clearly rising faster than wages. This makes labour relatively cheap and should help to support the demand for workers. The prices of consumer goods are now rising faster than both wages and the prices of other services. This limits how far people’s wages can go (reducing their purchasing power), making individuals and households poorer. Average pay growth has not diverged rapidly from the growth of productivity over this period.

What this all means is that different deflators reveal different things. Understanding the cost of living crisis requires looking at the relationship between wages and growth from many angles. With prices predicted to rise across the board during the remainder of the year, understanding different deflators and what they tell us is crucial.