The year ahead: the economy

Year three of Covid-19 brings a new wave of infections, but also a surging cost of living. So, although payroll employment is now above its pre-pandemic level and other indicators are heading in the right direction, economic and financial challenges lie ahead. Here are some of the issues to watch out for.

Key trends

• Cost of living: Inflation highs continuing at 5-6% in the first half of the year may drop away later – but don’t count on it;

• Incomes: earnings and pay may struggle to keep up, although unions will leverage labour shortages where they can, and a 6% rise in the statutory minimum wage will help;

• Taxation: National Insurance contributions rise in April, cancelling out some of the benefit of pay rises, and giving employers another reason to resist big awards;

• Growth: economic growth (GDP) of 5-6% could help fund pay and conditions and other workforce needs, like training;

• Supply and demand: labour shortages and other supply problems may continue to disrupt the economy, resulting in unmet demand for goods and services;

• Public spending: some public services will be boosted following last October’s Autumn Budget and Spending Review but the impact of these fiscal measures could be limited;

• Money: the Bank of England may again raise interest rates, cooling inflation by increasing the cost of borrowing;

• Trade: trade in goods and services could improve, or it could be set back by problems surrounding the UK-EU Trade and Cooperation Agreement; and

• Climate: the government is under pressure to make good its promises on climate change, de-carbonisation and the “just transition”.

Cost of living

The highest inflation for decades was revealed in figures published on 15 December. Retail prices index (RPI) inflation – the traditional measure, still used by pension schemes, and preferred by trade unions – rose to 7.1%. Consumer prices index inflation (CPI), rose to 5.1%, continuing to overshoot the 2% target that guides the Bank of England (BoE), while CPI with a housing element (CPIH) was 4.6%.

A year of two halves

Inflation is expected to remain high, at least for the first half of the year. It may come down after that as lower prices in 2021 drop out of the 12-month calculation, but predictions can be unreliable.

The government’s advisory Office for Budget Responsibility (OBR) predicted CPI inflation at 4.4% this year, but later accepted it might peak at close to 5% – which it has already exceeded.

November’s BoE Monetary Policy Report agreed with that 5% forecast for April-June, as household energy prices increase further, but it expects global goods price inflation to slow after that, as bottlenecks ease and demand swings back to services (see below).

More “durable” inflation?

Both the OBR and BoE recognise that price pressures could be “sustained over a longer period of time”. HM Treasury said the OBR was expecting inflation to return “quickly” to target by the end of 2024. As they see it, high inflation could become more “durable” if people come to expect it to continue, “for example if workers demand larger wage increases”. It helps the Treasury’s case that public sector pay increases might “exacerbate temporary inflationary pressure” by spilling over into higher wage demands across the economy or higher inflation expectations.

The National Institute for Economic and Social Research (NIESR), an independent forecaster, also expects 2022 inflation to fall back after the second quarter. But, looking back to a previous inflation overshoot back in 2011, it warns that getting back to 2% after a spike “can take a long time”.

By the final three months of this year, independent forecasters see RPI inflation running at 4%, with individual forecasts ranging from 2.8% to 6.2% (NIESR 6%, OBR 4.2%). The average forecast for CPI inflation over the same period was 2.8%, ranging from 1.85% to 5.1% (NIESR 3.7%, OBR 3.3%). These and other figures were from HM Treasury’s November Forecasts for the UK Economy.

Incomes

Inflation, at almost 6%, would eat away at average earnings, pay settlements and household incomes. As the UNISON public service union points out, any pay rise below that level is effectively a cut: “Many core items of expenditure are rising at ferociously high rates – housing at over 10%, petrol, gas and electricity bills in the region of around 20-30%”, it said.

Earnings

Last year saw some really big increases in average weekly earnings (AWE), but adjusted figures of around 4-4.5% are seen as more representative of the “underlying” trend. Looking ahead, independent forecasters see average earnings rising by 3.8% in 2022 (ranging between 2.7% and 7.5%). The OBR forecast was 3.9%.

The NIESR forecast is 4.5%, but it questions how sustained this relative recovery in wage growth will be, how widespread, and how much it will be eroded by inflation. Hours per worker are expected to grow relatively rapidly but, after inflation, real wage growth could be minimal (at best).

The BoE foresees a “marked slowdown” in AWE growth to 1.25% in the last quarter of 2022, according to Monetary Policy Committee member Michael Saunders. That’s partly based on the further unwinding of workforce composition effects (including those from the ending of furlough) but also lower underlying pay growth.

Pay

At these levels, earnings growth in 2021 was well above LRD’s 2% annual median for pay settlements. The difference (“wage drift”) may be explained by increased hours being worked, or the use of bonuses to top up wages. It suits the Treasury to argue that average pay settlements (rather than average weekly earnings) “are the appropriate measure of earnings growth to consider in setting public sector pay settlements”.

Labour shortages have clearly led to some big pay increases but there are doubts about how widespread those have been (and will be in 2022). That’s a worry for the TUC, which is making the case for a more planned approach to pay.

There were signs of uplift in wage deals at the end of 2021, and a lot may hang on how far employers apply April’s minimum wage increases to workers paid above the statutory minimum. The National Living Wage goes up by 6.6% to £9.50, while the 21-22 and apprentice rates go up by 9.8% and 11.9% respectively (4.1% for the 18-20 and 16-17 rates).

UNISON argues that these increases should act as a spur for pay rises across the labour market, but also anticipates that it may have to head off employer attacks on locational allowances (using increased home and hybrid working as an excuse). Household incomes are another area of concern, following the withdrawal of the £20 top up to Universal Credit.

Taxation

The new Health and Social Care Levy will add 1.25% to employee National Insurance contributions (NICs) from April. Employers will also have to pay 1.25% more. While the funds will help boost public spending (see below), it also means lower post-tax earnings and increased company overheads. That could result in lower wages being offered, as employees usually bear all the burden of payroll taxes (NIESR).

Growth

Pre-Omicron, expectations were that the economy would return to its pre-pandemic size “around the turn of the year”, the Treasury said, with the UK having the highest annual growth rate in the G7 group of countries. Output and growth are usually measured by gross domestic product (GDP) although it is arguably a poor measure of economic wellbeing. UNISON nevertheless hoped that growth “should escalate employers’ capacity to pay”.

Following a deep recession in 2020, the economy was still shrinking (by -1.4%) in the first quarter of last year. It grew by 5.5% in the second quarter and 1.3% in the third quarter, but slowed in October, as restaurants, energy and construction took a hit (health andsecond-hand car sales bucked the trend).

Risks

Independent forecasts for 2022 foresaw average growth of 5.1%, ranging from 3.5% to 8.1% (the OBR estimate was 6%). NIESR was less positive, with an estimate of 4.7% (falling to 1.7% in 2023), and that was before the arrival of the Omicron variant of Covid-19. Although we may be approaching “full employment”, real wages will continue to stagnate unless productivity improves, it said.

Downside risks to NIESR’s estimate include more disruption in the transport network and employers being unable to recruit staff. A more rapid easing of supply constraints, global vaccine roll-out, more accommodative monetary policy (see below) or changes to our economic behaviour (boosting productivity) could contribute to a more upbeat outcome.

Supply and demand

Problems with the supply of labour and the supply of goods both had a huge impact in 2021, but what about 2022?

Employment

The TUC saw the labour market as recovering but still fragile. The employment rate is up, but not in “hard hit” industries, but self-employment is still well down on its pre-pandemic level. Economic inactivity has increased but unemployment and under-employment are back close to pre-pandemic levels. Short-term unemployment is at a record low, according to Michael Saunders (a member of the BoE’s Monetary Policy Committee).

Independent forecasters (on average) see employment growing by 1.2% in 2022 (ranging from 0.3% to 3.0%). The OBR estimate is 1.1%. They see the unemployment rate at around 4.6% (forecasts range from 3.9% to 6%), compared with its peak last year at 5.1%. NIESR forecasts closely match these averages. The BoE expects the jobless rate to fall to 4% this year but rise later as demand growth cools.

But there is a debate about what this means for the economy. Vacancies were at a record high at the end of last year, while the ratio of unemployed people per vacancy fell to a record low of 1.3. UNISON thinks labour shortages, particularly in low-paying sectors, do seem likely to push employers further toward raising average pay increases (not a view that the Treasury seems to share).

But workers may be choosing not to return to sectors where pay and conditions are poor, the TUC argues. Its Jobs and recovery monitor said: “There is no market-led pay utopia here. It may even be that firms are using higher vacancies to try and source cheaper workers rather than increasing pay for existing workers”. Instead, they could increase wages by reducing the share of income taken as profits.

Goods and services

Demand swung away from services to goods during the pandemic, exceeding supply in some cases (gaps on supermarket shelves, queues outside petrol stations, shortages of building materials and cars’ computer chips). Any repetition this year could have an impact, although demand is swinging back towards services. Shrinking savings or rising debt could be an indication of how consumers respond to rising prices.

Public spending

Better than expected outcomes in the second half of last year saw chancellor Rishi Sunak announce spending increases (and relaxation of public sector pay constraints, but the significance of these measures is open to debate.

Of roughly £30 billion on average added to departmental budgets in each year of the Spending Review, around half goes directly from the new levy to health and social care (see above) with the other half undoing £18 billion of unspecified cuts to pre-pandemic spending totals. Together they are said to take public spending from 39.8% of GDP before the pandemic to 41.6% (“the largest sustained share of GDP since the late 1970s”).

But the TUC fears that the Treasury really wanted a return to the tight spending settlements that “sucked demand out of the economy” after the financial crisis. NIESR expects the government’s fiscal policy to inject “little additional demand into the economy”. Individual trade unions are well placed to interpret what all this means.

The NEU teaching union points out that the 2021 Spending Review provided for a real-terms growth rate of only 2% per year for education, less than previously expected: after a front-loaded “sugar rush” it will be back to business as usual. The NEU is also worried that there is insufficient provision to properly raise teachers’ starting salaries in England to £30,000, as promised.

The Community trade union, in its response to the Spending Review, highlighted needs not met for the steel industry (to address uncompetitive electricity prices and lay the groundwork for decarbonisation). It also says a delay in funding for childcare providers until 2024-25 will be “too late to help a sector in crisis now”.

Money and trade

A BoE decision to further raise interest rates from their historically low level of 0.1% can’t be ruled out, and nor can a change in its “quantitative easing” policy. NIESR expected interest rates to have risen to 0.5% by the middle of this year, but believes that some of the stimulus provided by monetary policy can be removed while the policy remains broadly supportive.

Trade patterns have changed as a result of the pandemic and Brexit, but any dispute over the EU-UK Trade and Cooperation Agreement (TCA) and the Northern Ireland Protocol will have an economic impact. A group of employers and some trade unionists (from Prospect and the Musicians’ Union) have formed an independent commission on UK-EU relations to establish what problems have been created, and to work to create viable solutions.

But it’s not all about Europe: Community, the largest union in the steel sector, is worried that when the US steel tariffs are lifted in January for the EU it will be incredibly difficult for UK industry to compete.

Climate

The greatest threat to global economic and financial stability is catastrophic climate change, according to the NIESR. The Glasgow Climate Pact adopted at Cop26 called on all countries to accelerate climate action and policy implementation and to strengthen national emissions reduction targets by this November.

Last month the TUC, CBI and green groups reminded the UK government that these instructions cannot just be for other countries to implement. They want to close the “adaptation gap” in the UK identified by independent statutory body the Climate Change Committee, and that means turning “just transition” from a slogan into a reality.