How does wage growth affect inflation and interest rate rises?

High inflation has been in the headlines since it began to creep up in early 2022. In the 18 months since then, it peaked at 11.1% in October 2022 before slowly falling to 8.7% in May 2023. 

The problem has been caused by a number of factors, but one that has been of particular concern in recent months is wage growth. Data reported by Sky News shows that in the 12 months to April 2023, average wages excluding bonuses grew by 7.2%, up from 6.7% in March. 

The data was unexpectedly high, leading some to predict that the Bank of England (BoE) would raise interest rates further than anticipated to continue their campaign to bring inflation back to the government’s 2% target. 

But how exactly does wage growth affect inflation, and could it lead to further interest rate rises?

Rising costs, labour shortages, and minimum wage increases have all contributed to wage growth

Average wage growth is an important measurement of economic growth because it indicates how much spending power the average consumer has. This can tell economists a lot about how well the economy is performing and what might happen in the near future. 

Wage growth can be influenced by a range of factors. The following three are thought to have caused wages to grow particularly quickly in the 12 months to April 2023:

1. The cost of living crisis has meant that more people have requested pay rises. This has been necessary for consumers to maintain their standard of living. 
2. The government increased the minimum wage and national living wage in April 2023. MPs made this decision to support those who are on the lowest incomes through the cost of living crisis. 
3. Labour shortages in several sectors mean that companies are having to offer higher pay to entice workers to start working for them or to retain their existing staff. 

High levels of wage growth can have a knock-on effect on inflation

While an increase to your wages can be a good thing for an individual, when the average wage in the UK grows as quickly as it has recently, it can lead to rises in inflation. 

In the first instance, when a company increases the wages it pays its workers, those additional costs need to be met from elsewhere. This usually means that the company will increase the price it charges for the goods and services it provides. 

When lots of companies across the country do this, it means that the average cost of goods and services goes up and, as a result, inflation rises for everyone. 

This can lead the BoE to raise interest rates in an attempt to bring inflation back to more acceptable levels. So, while wage growth can be a good thing for individuals, if it grows too quickly overall, it can create a vicious cycle.  

The Bank of England has been raising interest rates in a bid to bring inflation down

The BoE has been working hard to try and bring inflation back to its 2% target using interest rate rises since December 2021. There have been 13 consecutive rises to date, taking the base rate from 0.1% in December 2021 to 5% in June 2023. 

Minutes from the Monetary Policy Committee meeting for June refer to the higher-than-expected wage growth, drop in unemployment, and business surveys relating to economic growth among the deciding factors behind the 0.5% increase to the base rate. They also suggest that further rate rises could occur soon if inflation doesn’t fall when they expect it to. 

Interest rate rises could help to stabilise wage growth

Interest rate rises are often described as a “blunt tool” in the fight against high inflation, but there are a few ways in which they could affect inflation, and wage growth specifically. 

The first is that, by making borrowing more expensive, it encourages consumers to save rather than spend. This reduces demand for goods and services so that manufacturers must be more competitive on price to make sales. This, in turn, could help to bring inflation down to the 2% target, reducing the need for higher wages as price rises are less severe. 

Higher borrowing costs can hit businesses particularly hard. When it costs more to borrow money, a company may be less inclined to raise wages as they look to reduce spending costs elsewhere. 

Get in touch

If you’re concerned about how high inflation could affect your wealth, we can assist you in creating a financial plan designed to help protect your assets and enable you to live the lifestyle you dream of. Email enquiries@metiswealth.co.uk or call 0345 450 5670 today to find out what we can do for you.

Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.