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The Philips Curve: why is higher employment not leading to wage growth?

Low unemployment is not leading to higher wages. What is happening?

  • Unemployment is at its lowest level for over 40 years, but wages are declining in real terms
  • The 'Philips curve' appears to be breaking down
  • This may have an important implications for policymakers setting interest rates

This week unemployment hit new lows in the UK. At 4.3%, it is now at its lowest level since 1975. This should be good news all round, and, the Philips Curve suggests, should lead to higher wages and higher inflation. Yet wage rises continue to lag inflation and workers are seeing their salaries drop in real terms.

The Philips Curve suggests that as countries approach full employment, employees have greater bargaining power and employers have to pay more to recruit people. This should lead to higher wages, which in turn leads to higher inflation and forces interest rate rises.

This has been a key assumption for governments in setting policy and as such, the fact that it doesn't appear to work any more is causing some consternation. It was exercising central bankers at the recent Jackson Hole symposium, for example. The debate is focused on whether this phenomenon is structural, or temporary.

Miton Optimal attributes the problem to 3 'D's - Debt, Demographics and Disruption. High levels of debt are putting a brake on consumer spending. Weaker demand means that companies have less pricing power and therefore less money to pay workers.

Aging populations also play a role: Miton Optimal says: "As an individual ages, savings exceed spending and this causes downwards pressure on prices. As a whole, the world has crossed the tipping point when net savings turn positive." Finally, and perhaps more importantly, is disruption. Amazon, Airbnb and Uber are wreaking havoc on incumbent companies, leaving them with no pricing power.

What does this mean? Miton believes central banks will be less likely to raise interest rates because of wage and price inflation in future than because of asset inflation and the risks represented by moral hazard. However, for the time being, they remain 'backwards-looking and relying on old models that have ceased to be relevant'. This is nevertheless good for borrowers because it is likely to leave interest rates low even as asset prices are rising.

It also means that full employment may not deliver the benefits that policymakers hope. Central bankers may need to find other ways of assessing the appropriateness of monetary policy.


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