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Inflation: a wage-old problem for policymakers

Employment and pay growth remain high, so how will the Bank of England contain core inflation?

The economic growth data suggest a future undershoot of the 2% inflation target, and the wage data an overshoot. What to do?

All might not be lost. A more forward-looking approach might support greater policy loosening – or more pre-emptive interest rate easing, given the lag between a cut and its eventual effect on the economy. And the Bank may indeed take this course. Much is likely to hinge on how National Insurance tax rises impact employment

What to make of pay data?

Wage surveys are generally consistent with moderation in the official AWE data. However, there is some variation in the survey data and, because they measure subtly different things (e.g. pay on advertised jobs, basic pay settlements, wage expectations), there is not a direct read-across to AWE (the economy-wide wage bill, adjusted for working time).

Wage inflation & surveys

Source: ONS, BoE, Brightmine, Incomes Data Research, Indeed, NatWest

Early indicative survey data for pay settlements in 2025 suggest a moderation (HR specialists Brightmine has indicated 3-3.5% year-on-year for median settlements). These softer wage trends appear consistent with falling vacancies and a falling vacancies-to-unemployment ratio.

Admittedly, the pace of decline in vacancies is slowing, but the looming National Insurance payroll tax hike might disincentivise business hiring.

Does this all point to falling wage inflation pressures, and reason to cut rates? A forward-looking BoE might think so.

Our predictions or employment and rates

In the first half of 2025 we foresee ongoing wage inflation pressure for the BoE to contend with. But wage inflation is expected to tail off in the latter part of this year – we forecast around 3.75% in Q4 2025 and around 3% from mid-2026.

This would be consistent with Consumer Price Inflation (CPI) sustainably meeting its target. But a lot could happen in that 10 months. We think that 2025 and 2026 will see larger declines in employment than in recent cycles, starting this spring and building steadily throughout the year. That would trigger fundamental changes in the market’s expectations and behaviour, thereby shrinking inflation nearer to target.

Given the latest data, we have updated our forecast for BoE Bank Rate. We now forecast 25bp Bank Rate cuts in February, May and August, taking Bank Rate to an unrevised 4.0% terminal rate. This amounts to a modest adjustment to the timing of monetary policy easing, rather than a more fundamental change of view.

But there are risks in both directions to our forecast, notably to the downside in 2026 in response to more severe than expected job cuts. The degree of continuing stickiness in wage and services inflation has left us with a more cautious view of near-term monetary policy easing – ditto the degree of fiscal stimulus unleashed in the October 2024 Budget (£40bn, or 1.3% of GDP, in 2025-26).

Ultimately, the BoE’s mandate is inflation-targeting and it’s through this focus that it will maintain legitimacy. Given the overall pressures on inflation, we maintain that terminal policy rates will be at the upper end of market expectations.

To read more market views from our Strategy Team, visit here 

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