The Role Of Labour Costs And Profits In UK Inflation - 2010 To 2023

11th October 2023

Analysis of trends in unit labour costs and unit profits as contributions to domestic inflation using the national accounts and the income approach to GDP.

The change in the implied price of UK gross domestic product (GDP) is a measure of domestic inflation, which includes capturing the contributions of labour costs and profit margins in explaining movements in domestic inflation.

In the year to Quarter 2 (Apr to June) 2023, this measure of domestic inflation increased by 7.9%; higher unit labour costs contributed about two-fifths (3.3 percentage points) and higher unit profits contributed about one-fifth (1.6 percentage points) of that increase in domestic inflation over this period, which is broadly in line with previous inflation cycles.

There has been no clear increase in the relative contributions in unit labour costs and unit profits in recent quarters; higher unit labour costs played a relatively larger role in the 1970s in their contribution to domestic inflation in the UK after the oil price shocks.

There has not been a marked change in the labour and capital income shares in recent quarters for the G7 economies.

Contributions to domestic inflation do not necessarily imply that inflation is high because labour costs and/or profits have increased, as any change in labour and capital income might be reflecting a response to higher inflation, especially in cases of external shocks.

Background
There has been interest in whether higher labour costs or higher profits have played a role in underpinning domestic inflation in the UK and other advanced economies. The increase in energy and other commodity prices prices helps explain the initial pickup in inflation in the UK, which was reflected in a decline in the UK's terms of trade, where higher import prices led to higher consumer prices.

These terms-of-trade effects also explain why there must be a hit to real national income in the UK, which would be reflected in lower labour income for households and/or lower capital income for businesses. However, it is possible that households and businesses might respond in preserving their real purchasing power. Changes to the wage- and price-setting process could lead to higher labour costs and higher profit margins, particularly if there is a tight labour market or if firms have pricing power.

Underlying consumer price inflation in the UK remains higher than in other advanced economies (Table 1). Most measures of the persistent inflation component have increased. This persistence of inflation points to the potential role of higher labour costs and/or higher profit margins in underpinning domestic inflation in the UK. For instance, the International Monetary Fund find that higher profits have played more of a role in inflation in the euro area, while higher labour costs have been more of a factor in the United States.

We look at how domestic inflation has evolved in the UK, specifically whether there has been a change in the relative contributions of unit labour costs and unit profits. We also look at how the UK experience compares with other advanced economies to see how labour and capital income have evolved in recent years.

Read the full article HERE