Unemployment is up, so inflation is down, and that is one of the oldest and most enduring relationships in economics. One former chancellor, Norman Lamont, said more than 30 years ago that a rise in unemployment was a price worth paying for getting inflation down; he did not last too much longer in the job.
The Phillips curve — the inverse relationship between unemployment and inflation — is one of the building blocks of economics. It is named after the New Zealand economist AW “Bill” Phillips, who pinned down that relationship at the London School of Economics in the 1950s.
The curve, which illustrated that when unemployment goes up, wage inflation comes down, and vice versa, was estimated on the basis of UK data from 1861 to 1957.
Phillips, who died in the mid-1970s aged only 60, came to economics as a war hero captured in Java, spending years as a Japanese prisoner of war. He was extraordinarily creative: as well as the curve, he invented the Phillips machine while still a (mature) student at the LSE — an early economic model consisting of a series of hydraulic pipes and tanks (some of them taken from decommissioned Lancaster bombers), of which a dozen or so were made for commercial and policy use. There are to this day at least three in the UK — at Leeds and Cambridge universities and the Science Museum in London.
The Phillips curve, or developments of it, remains very important. The Bank of England’s monetary policy committee — which is now odds-on to cut interest rates next month, and again after that — is heavily influenced by the amount of “slack”, or spare capacity, in the economy. The more slack there is, the lower inflation is likely to be pushed; unemployment is a key component of such slack.
Anyway, the inverse relationship between unemployment, wage inflation and price inflation looks to have been solidly confirmed by the latest data. The UK unemployment rate rose to 5.2 per cent, or 1.88 million people, in the October-December period of last year. This was 0.8 percentage points, or 330,000 people, above its level a year earlier, and more than half a million above two years earlier, when we were just emerging from an incredibly tight post-pandemic labour market.
Rising unemployment, it seems, has done the trick of bringing down inflation and will continue to do so. Consumer prices inflation fell from 3.4 per cent in the year to December to 3 per cent in January and looks to be firmly on its way to the 2 per cent official target in the spring, as the Bank of England now expects.
Meanwhile, wage inflation, measured by average earnings growth for regular pay, fell from 4.4 per cent in the three months to November, to 4.2 per cent in December, with private sector earnings growth dropping to 3.4 per cent. Higher unemployment reduces the bargaining power of workers. When the distortion that has pushed up public sector earnings growth to more than 7 per cent drops out of the figures, earnings growth overall should be down to 3 per cent or so, which is broadly consistent with keeping inflation at the target of 2 per cent.
I could stop here, celebrate how a straightforward piece of economics works nearly 70 years later, and move on. There are, however, some necessary details to add on both unemployment and inflation.
On the fist of these, as I have pointed out before, it is necessary to take the unemployment rate and the economic inactivity rate — people who are not in work and not available for it — together.
A year ago, the unemployment rate was 4.4 per cent and the inactivity rate among working-age people was 21.5 per cent, making a combined total of 25.9 per cent. In the latest figures, the unemployment rate of 5.2 per cent ran alongside an inactivity rate of 20.8 per cent — a combined 26 per cent.
There has been a softening of the labour market, for well-known reasons, but it is quite a small one. Statistically, most of the increase in unemployment reflects a reduction in inactivity; people have been making themselves available for work, without necessarily finding it.
There is plainly a problem with youth unemployment — those aged from 16 to 24 — which has been higher than the EU average since at least last summer and is now 16.1 per cent. That and the related problem of “Neets” — with nearly a million young people not in employment, education or training — represents a huge challenge.
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Again, though, some of the rise in the youth unemployment rate reflects a fall in inactivity. The unemployment rate for 18 to 24-year-olds has risen from 12.8 to 14 per cent over the latest 12 months, but their inactivity rate has dropped from 32.8 to 29.9 per cent.
Those “well-known reasons” for rising unemployment are another caveat. Employers often say the softness of the labour market is due to their reluctance to recruit workers because of the impact of government policy, rather than to weak business conditions. Increased employment costs — including for employers’ national insurance and the minimum wage, particularly for young people — and enhanced workers’ rights have reduced hiring and increased redundancies.
This is also straightforward economics, of course. If you increase the cost and convenience of employment, then you can expect less of it. And, whatever the causes of a rise in unemployment, it still has the effect of creating slack and bearing down on inflation.
As for inflation, there is also a caveat. Not all inflation is the result of what you might call natural economic processes, nor is it all driven by market forces. Some of our most important prices are, in the jargon, “administered” — in other words, set directly or indirectly by the government.
One dog that did not bark louder in the latest inflation figures was something that economists had thought would be an important factor in pushing the rate down. This was that VAT was imposed on private school fees in January last year. When it was, it resulted in an education inflation rate of 7.5 per cent, including 12.7 per cent for private school fees (schools absorbed some of the VAT increase).
The effect this time, with no additional VAT, was not as striking as expected, with education inflation still running at a chunky 5.1 per cent last month. Mechanically, education contributed to the fall in inflation last month, but it was small: just 0.07 percentage points.
There will be bigger administered price reductions in the coming months, including the effect of lower energy bills as a result of measures announced by Rachel Reeves in her November budget, and the freeze on regulated rail fares and prescription charges. These, particularly the energy announcement, will provide much of the “one last push” needed to get inflation down to the 2 per cent target. The Bank of England’s challenge will be to keep it there.
So, it is a multi-faceted picture. We should celebrate that inflation is coming down to the official target but worry how a labour market that was previously an aggressive generator of jobs no longer is, although the very latest evidence suggests it may be stabilising. And we should salute Bill Phillips, half a century after his death.
PS
I often mention productivity, and the need to improve it, in this column. One big story of last year was the Office for Budget Responsibility (OBR) revising down its productivity forecast, with adverse consequences for the public finances.
Economists have sometimes called the productivity slowdown that followed the 2008-9 global financial crisis a “puzzle”. Well now there is another puzzle.
New official figures published a few days ago show that, if anything, the productivity problem is getting worse. The figures, using the Labour Force Survey, show output per hour worked in the final quarter of last year was down by 0.5 per cent on a year earlier, while output per worker was 0.2 per cent lower.
The Office for National Statistics (ONS) has other data up its sleeve, however, based on PAYE (pay as you earn) real-time information from HM Revenue & Customs. These are the figures that every month are the source for numbers of people on payrolls. Using these produces a very different picture, with output per hour up 1.6 per cent over the latest 12 months and output per worker up 2 per cent. Looking at these, you might say: what productivity slowdown?
The ONS will try to pull these disparate strands together when it consults users on how best to proceed with the productivity statistics.
I, for one, hope that the UK’s productivity problem does not come to be seen as a statistical aberration. If it did, not only would it give me less to write about, but it would also mean that we would have to look for another excuse for our underwhelming economic performance over the past decade and a half.
david.smith@sunday-times.co.uk