UK QUARTERLY ECONOMIC OUTLOOK | Q2 2025
Labour market
Looser market will slow pay growth
There is now clear evidence that the surge in employment costs that came into effect in April has had a chilling effect on demand for labour and probably will continue to do so for the rest of the year. However, so far at least, there is no sign of a surge in unemployment. A looser labour market will serve to take some of the heat out of exceptionally strong pay growth, though.
Budget puts the brakes on hiring
In the wake of last year’s Autumn Budget, survey measures showed firms’ hiring intentions collapsing. Six months on, the hard data instead suggests the labour market is actually only gradually easing and the significant rounds of layoffs feared at the time haven’t happened.
Yet, different sources of data paint very different pictures of the labour market. The Labour Force Survey (LFS), which is the official source of employment data, suggests employment has grown 0.6% since the Budget and the unemployment rate has only ticked up gradually to 4.5%. However, payrolls data suggest a 0.5% fall in employment over the same period, pointing to a much quicker loosening.
Higher employment costs were not felt equally
That contrast may seem unusual, but it is for two reasons. First, they measure slightly different things. The LFS captures a broad range of employment, including many self-employed workers, whereas payrolls data only captures PAYE employees. Second, despite recent improvements to the LFS, it is still plagued with data-quality problems, making it unreliable.
The result is that we are forced to look at a much wider range of labour market indicators now than before the pandemic. The clear message is that labour demand has cooled rapidly and firms’ response to higher employment costs has been to freeze hiring and not replace outgoing employees as opposed to a swathe of redundancies.
Unsurprisingly, given the large minimum wage increases and the way employer NICs was reformed, higher employment costs were clearly not felt equally across the economy and impacted lower-paid sectors the hardest. Hospitality and retail firms make up over two-thirds of the fall in payrolls since the budget.
Given the subdued outlook for growth thanks to Trump’s tariff turmoil we think it’s unlikely the labour market will pick up steam anytime soon.
Will wage growth slow?
Looking ahead, we think the labour market is over the worst of any post-budget hurdles, so while it will probably remain cooler than it has been, we expect the labour market to only weaken gradually. Indeed, even as the unemployment rate keeps nudging up, an unemployment rate below 5% would still suggest the labour market is in good shape by historical standards.
What’s more, we also expect wage growth to slow from its current 5.5% rate for two key reasons. First, that extra slack from weaker labour demand and slightly higher unemployment will make it harder for workers to bargain for big pay rises as competition amongst firms for employees’ fades. Second, firms will be under pressure to protect their profit margins after the rise in employment costs in April and will want to try and pass some of that cost onto employees through less generous pay rises.
However, we see a couple of big risks to the outlook. First, there’s a chance that we are yet to see the full effect of the rise in NICs and firms remain reluctant to hire new employees in the face of higher costs. That will continue to put downwards pressure on employment and could weigh on growth as activity slows.
Employees are reluctant to accept falls in their real incomes
Ordinarily, that should prompt a quicker fall in wage growth, but the second risk is that wage growth remains stubbornly high despite a weakening labour market. Inflation remains well over 2% and employees have shown a greater reluctance to accept falls in their real incomes after years of above target inflation. That would further increase the pressure on firms to increase prices and risks creating a situation where firms raise prices to protect their profit margins against higher costs, which of course raises the risk employees ask for even more pay rises, driving up inflation. That would put the Bank of England in a difficult position if wage growth remains strong despite a weak labour market.
Ultimately, we expect only a slow and steady increase in the unemployment rate going forward. We also expect that a weaker labour market and firms trying to recoup the rise in employment costs means pay growth ends the year at around 4%, which would still be higher than the MPC are comfortable with.
