UK Inflation Slows, Undercutting Wage Growth Worries (Again)

When the UK Office for National Statistics (ONS) announced wage growth surged to a record-high 7.8% y/y in the three months through June, you might think it caused a national cheer to learn pay has finally caught up with the inflation rate, giving consumers some relief.^[i] But that wasn’t the case. Instead, as usual, pundits warned rapid wages would entrench fast inflation, perpetuating the vicious wage-price spiral. Sure, inflation has been slowing lately, but it won’t last. That is what we are told, and headlines pinned UK stocks’ Tuesday drop on this apparently grim reality.

This is a very, very old theory—and one we think reality has disproved time and again. The Fed, Bank of England and pretty much all major central banks consider it a foregone conclusion that wages drive inflation, presuming businesses raise prices to cover higher labor costs (which forces more wage hikes, forcing more price hikes, lather, rinse, repeat). This is why the Fed has a dual mandate of balancing unemployment and inflation—Congress fell for the myth that when unemployment is low, workers have more bargaining power to secure wage hikes, which drives inflation, while high unemployment reduces wage inflation pressures. Yet time and again, wages have followed inflation. To anyone familiar with Milton Friedman, this isn’t a surprise. He argued—and showed—in the late 1960s that businesses factor in inflation when adjusting pay to compete for workers. Putting it another way, they compete on real, inflation-adjusted wages. Not nominal. If this weren’t true, high unemployment would have torpedoed inflation in the 1970s. It didn’t.

The aforementioned UK wages provide more evidence. What happened a day after that record-setting wage growth hit the wires? Only the news that July’s inflation rate eased from 7.3% y/y to 6.4% when using the ONS’s preferred measure, the consumer price index including owner-occupiers’ housing costs (CPI-H).^[ii] (The more widely reported figure, headline CPI, also slowed—from 7.9% y/y in June to 6.8% last month.^[iii]) This extends a trend of moderating inflation and accelerating wages that began last October.

Exhibit 1: Fast Wage Growth, Easing Inflation

Source: FactSet, as of 8/16/2023. Average weekly earnings excluding bonuses (rolling 3-month average) and CPI including owner-occupiers’ housing costs, year-over-year changes, December 2021 – July 2023. Wage growth data run through June 2023.

If wage growth caused inflation, this wouldn’t be happening. But here in Reality Land, there is no vicious cycle—just some long-awaited relief for consumers who have weathered a big cost-of-living storm. Not just from inflation and energy costs, but from a range of stealth tax hikes. Wage growth finally passing inflation should support continued spending growth from here, helping the UK gradually overcome an economic headwind.

There is a silver lining from headlines continuing to interpret wage growth as negative: It keeps the pessimism of disbelief alive, extending stocks’ wall of worry. When headlines couch good news as bad, it keeps expectations low, making it quite easy for reality to deliver positive surprise. This doesn’t preclude more volatility, but we think it points to UK stocks’ tough 2023 to date being a sentiment-driven, correction-like pullback (and in pounds, an actual correction), not the start of something much worse.