Unit 4 Macro: Unit Labour Costs and Inflation

Over many years the rate of change of unit labour costs (ULCs) has been a decent reliable indicator of inflationary pressures in the UK economy. Times when wage costs adjusted for productivity have grown quickly have often coincided with a rise in the annual rate of inflation - little wonder when payroll costs are a sizeable chunk of operating expenses for many businesses.

But in the last couple of years we have seen a growing disconnect between unit labour cost inflation and the published figures for CPI.

Notice in the diagram above how there has been a large fall in unit labour cost inflation, indeed the rate has become negative at points since the start of 2010. Hundreds of thousands of workers in Britain have been asked to take wage cuts or perhaps a wage freeze as economic conditions have deteriorated - this has been the major factor driving down the annual growth of labour costs.

Over the same period, CPI inflation has been on a rising path (although the Governor of the Bank of England continues to predict that inflation will head south as we move into 2012).

Combine the two - low wage growth and above-target inflation and it is easy to see why millions of people in the UK who have jobs are experiencing a cut in their real incomes thus limiting their ability to spend on goods and services and raising the possibility of a second recession.

According to new research from the Institute of Fiscal Studies, living standards in Britain have fallen as a result of high inflation and low wages. An estimated £2,000 is said to have been wiped off the average family income since the start of the recession.

Further reading: UK seeing a big rise in poverty, says IFS (BBC news)