Amidst difficult economic conditions, how will the UK labour market hold up?

Nick South: The UK is currently in a very challenging economic situation and yet the labour market still appears extremely strong - how can we explain that? Will this downturn potentially look different to earlier ones?

Raoul Ruparel: It is certainly unusual; I don’t think we’ve entered an economic slowdown with unemployment at this sort of level since the early 1970s. At a headline level the labour market is strong, employment is near record highs, which remains one of the few positive economic indicators. But while the labour market looks strong on the surface, much of it is down to the persistent rise in economic inactivity in the UK following the combination of the pandemic and Brexit. The overall size of the workforce is therefore a lot smaller than it was expected to be before the pandemic, resulting in an extremely tight labour market and a shortage of workers in several sectors.

In terms of whether this time is different? Well, most other recessions haven’t started with the labour market where it is now, so it may take some time for the tightness to unwind – which helps support growth. Also, given we are now expecting a shallow but long recession, we may see firms trying to hold onto labour for fear that they will struggle to rehire these workers once the worst is over. We also have the strange situation of real wages falling sharply already ahead of the expected downturn, which suggests upward pressure on nominal wages might continue longer than expected because households are being squeezed hard by inflation.

NS: Both the US and Europe are also facing tight labour markets – is the UK situation different?

RR: Many countries saw a similar rise in economic inactivity during the pandemic – in a lot of cases this was due to early retirements, staying longer in education and, of course, longer-term sickness. While most have seen that reverse or begin to reverse, the UK has not. In fact, latest data out today shows inactivity rose slightly and remains at elevated levels.

?The UK also has structural changes to contend with such as Brexit, which has reduced the supply of labour in a way other countries haven’t seen.

We’re also seeing a confluence of structural problems in the health care system potentially affect inactivity, with many of those inactive being off with long-term health problems. The UK isn’t alone in this – notably France, Italy and Spain have all seen increased strains on their health systems post-pandemic, but it is another structural challenge that isn’t likely to change any time soon.

Moreover, the UK is coming into this off the back of almost 15 years of basically no real wage growth while also facing inflation that is both high and quite broad based, driven by domestic factors, and not solely energy prices. This is essentially a combination of the inflation challenges seen in the US and Europe.

So, while similarities can be found elsewhere, it does feel as if the UK is facing more structural and permanent labour market changes than other countries.

NS: How have organisations been responding to the trends we've seen in the labour market over the last 12 months?

RR: We’ve seen real competition for talent and growing power for workers.

Over the past few years, we’ve started to see compensation growth outstrip companies’ operating surplus, while for the past two decades they had tended to grow in parallel. Essentially, firms have seen lower growth in profits because they’re having to put more money and investment into securing the workers they need. ?

Specifically, we’ve seen a spike in bonus payments across a variety of sectors and not just in areas you might expect, like finance. Firms have been using abnormal bonuses to both attract and retain workers.?

There’s also been a strong emphasis on aspects beyond just pay that can attract or keep workers. For example, a lot of attention has been paid to the overall employee experience and what can be improved beyond just renumeration.

We’re also seeing an increasing desire to build skills internally and train people up, rather than just recruit those skills that are needed, as some are in such short supply.

Finally, we’ve also seen a rise in remote hiring. So, where possible, firms are looking abroad to hire remote workers to fill the skills gaps we’re seeing locally.

NS: How are UK businesses expecting the labour market to evolve over the coming year and what actions are they likely to take as a result?

RR: Despite quite a negative economic outlook, most businesses that BCG works with are expecting the labour market to remain tight for some time to come. Like us, they see a lot of the factors behind it as structural. This at least suggests employment could remain higher for longer than might be expected given the wider economic circumstances, which is a positive. But, they also expect upward wage pressures and certain worker shortages to persist well into next year. This is true even as we see early signs of hiring impulses and vacancies ease.

In many cases, this means they’re doubling down on the employee experience aspects I mentioned and thinking more broadly about how to retain workers.

In particular, organisations are thinking about how best to hold onto workers during a downturn. They often don’t want to risk letting go of good workers only to find they’re still facing a very tight labour market a year or two down the line. Not least because we often see that companies who are seen to show commitment and support to workers during a downturn reap longer term benefits, including loyalty, in return.

Of course, from an economy-wide perspective this could become a bit self-fulfilling. If most firms adopt this approach and don’t expect the labour market to ease, it won’t.

NS: What does this view of the labour market mean for the UK longer term?

RR: Well, in the longer term these structural changes mean the UK could have a persistently smaller labour force, which could become a limit on supply and, therefore, on broader economic growth.

In the shorter term, the picture is more mixed. On the one hand, if the tight labour market persists, we could continue to see upward pressure on wages which in turn means inflation may stay higher than expected. Of course, on the other hand, this means unemployment would be lower and pay might be better. As such, people’s incomes will be protected so it may mean demand is supported and growth is therefore underpinned more than expected. Especially in the short term, we’d expect the positive impact on growth to dominate.

The impact of, and response to, all this is also complex. Often, the debate is presented as a basic choice between recruiting workers or investing in capital machinery to replace them. But it’s rarely that simple. As we’re seeing, many firms are now switching to hiring remote workers when they face local shortages. Of course, this means that their wages are leaving the country and being spent elsewhere. So, the confluence of the changing nature of work – especially in a services-driven economy – and a very tight labour market are presenting some new challenges we haven’t seen before in the UK, which could have important implications. But it’s too early to say how all of this might play out.?