Pay settlements seen as key to prospects

DIANE COYLE

Economics Correspondent

The outlook for wages is one of the biggest uncertainties about inflation prospects highlighted in the Bank of England report.

The reason for the uncertainty is that growth in underlying average earnings has been unexpectedly low this year - even though basic pay settlements have been edging up and unemployment has fallen further faster than in previous recoveries. Annual earnings growth has fallen to 3.25 per cent, and nobody is sure why.

The Bank puts forward two diametrically opposed explanations for the surprisingly good behaviour of wages so far. The pessimistic view is that the reaction to the big fall in unemployment and creation of extra jobs has been delayed, and is about to take place. There has been an unusual absence of ``wage drift'' - increases in earnings above basic settlements such as bonuses and overtime pay. The shift towards lower-paid, part-time work would also tend to reduce measured average earnings.

Wage drift has always tended to rebound quickly in the past. It might do so soon. In addition, skills shortages tend to emerge a long way into a recovery, so this could be on the horizon again now.

Pay settlements have already picked up to about 3.5 per cent from 3 per cent at the start of the year. The current Ford and Vauxhall negotiations and the cluster of settlements in January will be crucial.

The optimistic explanation is that there is far more slack in the labour market than conventional measures suggest. Deregulation and flexibility mean that the level of unemployment below which inflationary pressures emerge is much lower than it was in the 1980s. If this is true, unemployment can safely fall much further and a slight upward move in pay settlements has no troubling implications for the inflation outlook.