Published as part of the ECB Economic Bulletin, Issue 1/2025.
While headline inflation has decelerated significantly across advanced economies in the past two years, services inflation has remained high. Since peaking in mid-2022, headline inflation in advanced economies (excluding the euro area) has declined significantly, supported mainly by falling or negative contributions from energy and core goods prices (Chart A). At the same time, services inflation has remained high, representing by far the largest component of headline inflation.[1] This box analyses the main drivers of services inflation in the United States and the United Kingdom, disentangling services inflation excluding rents from rent inflation, as they follow different dynamics. Specifically, the box highlights the role of labour market tightness and catch-up dynamics in non-rent services inflation.[2]
Chart A
Headline inflation in selected advanced economies
(annual percentage changes, percentage point contributions)
Sources: OECD, Haver and ECB staff calculations.
Notes: Constructed as the weighted average of eight advanced economies excluding the euro area (United States, United Kingdom, Canada, Japan, Norway, Denmark, Sweden, Switzerland). The latest observations are for October 2024.
In the case of non-rent services inflation, empirical analysis suggests that wage growth has been a key driver. The results of an econometric analysis indicate that wage inflation has generally been the main driver of core services inflation excluding rent (Chart B).[3] Input prices also played an important role in the strong rise in services inflation in 2022 and 2023, when producer prices inflation was pushed up by supply bottlenecks and large energy shocks, reaching levels twice as high as before the outbreak of the COVID-19 pandemic.[4] However, as input price pressures have receded on the back of a strong deceleration in producer price inflation, nominal wage pressures have become the main driver of services price inflation. The sources of inflationary pressures have thus shifted away from global and towards domestic factors, reflecting second-round effects as nominal wages start to catch up with inflation.[5] This is consistent with persistently high nominal wage inflation in the United States and the United Kingdom, which stood at 3.9% and 5.3%, respectively, in the second quarter of 2024, and the persistence of services inflation, despite downward pressure stemming from other factors.
Chart B
Wage contribution to non-rent core services inflation
(annual percentage changes, percentage point contributions)
Sources: National sources, OECD and ECB staff calculations.
Notes: The decomposition is based on the Bank of England’s Monetary Policy Report – August 2024. The model employed is an ARDL model using non-rent services inflation, wage growth, labour productivity and producer price inflation, estimated on quarterly data from 1988 to 2024. The wages-productivity differential is computed as the sum of the respective contributions of nominal wage growth and labour productivity. The latest observations are for the third quarter of 2024.
Labour market tightness and catch-up dynamics have been the main contributors to the post-pandemic acceleration of wage growth and its recent moderation. An examination of the factors underlying nominal wage inflation suggests that a large part of wage growth developments in the United States and the United Kingdom can be attributed to labour market tightness and lagged inflation, reflecting second-round effects as nominal wages catch up with previous inflation (Chart C).[6] In the United States, both labour market tightness and high inflation rates have contributed to the acceleration in wages since 2021. After the peak in mid-2022, wage growth started to decline again, equally supported by a softening of labour market tightness and lower inflation. By contrast, in the United Kingdom the timing of the contributions of these two factors to wage growth was different. Labour market tightness played a strong role in the initial wage acceleration after mid-2021, mainly owing to UK-specific conditions, such as a decline in the labour force driven by increased long-term sickness and Brexit-related labour shortages.[7] Lagged inflation, probably linked to second-round effects, started to play a more prominent role in the second half of 2022. Since late 2022 and early 2023, labour market tightness has started to ease, while lagged inflation has remained the main driver of wage growth above pre-pandemic levels.[8]
Chart C
Decomposition of nominal wage growth
(annual percentage changes, percentage point contributions)
Sources: US Bureau of Labor Statistics, US Bureau of Economic Analysis, UK Office for National Statistics, OECD and ECB staff calculations.
Notes: The decomposition is based on Yellen, J.L., “Inflation, Uncertainty, and Monetary Policy”, op. cit. The model uses private sector wage growth, labour productivity, lagged inflation and labour market slack, and is estimated using data from 2007 to 2023. The latest observations are for the third quarter of 2024.
Forward-looking indicators point to a moderation of wage growth. The Indeed Wage Tracker is generally considered a leading indicator for wage growth as it is based on pay offers included in new job ads online. The latest data from the tracker point to a decline in wage growth for the United States and a stabilisation at relatively high levels for the United Kingdom (Chart D). In the third quarter of 2024, the Indeed Wage Tracker for the United States was in the range of 3 to 3.5% for the third consecutive quarter, showing signs of stabilising at its pre-pandemic level. In the United Kingdom, the tracker has stabilised at an annual growth rate of 6 to 7% for the last three quarters. Hence, while the actual nominal wage growth series in the United Kingdom is showing clear signs of gradual disinflation (Chart C), and forward-looking business surveys point to a moderation, there remains some uncertainty around the extent of the moderation, as suggested by the unchanged value of the Indeed Wage Tracker. The latest readings of the ratio of vacancies to unemployment, an indicator of labour market tightness, also exhibited substantial signs of easing and a return to pre-pandemic averages for both countries. This is consistent with a likely, albeit delayed, cooling of UK wage inflation going forward.
Chart D
Forward-looking indicators of labour market tightness and wages
(left-hand scale: index: 2019 = 100; right-hand scale: annual percentage changes)
Sources: US Bureau of Labor Statistics, US Bureau of Economic Analysis, UK Office for National Statistics, Indeed Hiring Lab and ECB staff calculations.
Notes: Labour market tightness is measured as the ratio of vacancies to unemployed persons. The latest observations are for September 2024.
In addition, rent inflation accounts for a non-negligible part of services inflation in the United States and the United Kingdom. Rent inflation (excluding owner-occupied housing) accounts for 12% and 16%, respectively, of US and UK services inflation.[9] Rent inflation tends to exhibit strong persistence, since only new contracts and agreements renegotiated for contractual reasons affect the stock of rental agreements. Hence, large inflationary shocks – such as seen in recent years – pass through to overall rent inflation only with a lag. From 2021, rent inflation lifted off in the United Kingdom and even more so in the United States, where it appears to have peaked in mid-2023 (Chart E). Data from independent rental brokers on new rental agreements, which show a high correlation with one-year-ahead CPI rent inflation, suggest that, in the near term, rental inflation should decrease further in the United States and start easing in the United Kingdom.
Chart E
Early indicators of rent inflation
(annual percentage changes)
Sources: Haver, Zoopla Rental Index (United Kingdom) and US Bureau of Labor Statistics.
Notes: Quarterly observations computed as three-month averages of monthly data. The latest observations are for the third quarter of 2024. Owing to data availability, the observation for the third quarter of 2024 for “New tenant rent – United Kingdom” corresponds to July 2024.
A moderation in wage growth and rent inflation should bring down services inflation, although the pace of disinflation remains uncertain. Forward-looking indicators are pointing to a deceleration in wage growth and rent inflation amid still restrictive monetary policy in both jurisdictions. Should wage growth and rent inflation decelerate in the near term in line with these forward-looking indicators, UK and US services inflation can be expected to decrease. However, the pace of disinflation remains uncertain, and more persistent than expected services inflation could be fuelled by enduringly high wage growth, particularly if the labour market remains tight or if workers continue to make high wage demands in response to the erosion of real wages by past inflation. Moreover, structural shifts in wage and price-setting behaviour might have contributed to the recent inflationary persistence and might continue to do so in the period ahead.[10]
One factor behind the strong contribution of services inflation, compared with core goods, energy or food, is the larger weight of services in the consumer price index (CPI): 53.9% based on OECD weights, compared with 25.6% for core goods, 12.7% for food and 7.8% for energy. This may also reflect a slower pass-through of energy price shocks to services inflation than to energy and core goods inflation (see, for example, Kilian, L., “The Economic Effects of Energy Price Shocks”, Journal of Economic Literature, Vol. 46, Issue 4, December 2008, pp. 871-909).
For an analysis of the role of catch-up dynamics in wage inflation in the euro area, see the box entitled “Recent developments in wages and the role of wage drift”, Economic Bulletin, Issue 6, ECB, 2024.
The model, based on the Bank of England’s Monetary Policy Report – August 2024, is an auto-regressive distributed lags (ARDL) model, with non-rent services inflation as an endogenous variable, and nominal wage growth, labour productivity and producer prices inflation as exogenous variables, and is estimated on quarterly data from 1988 to 2024. In line with the literature highlighting that price changes are influenced by the differential between nominal wages and labour productivity (when nominal wage growth exceeds labour productivity growth, the cost of labour per unit of output increases, pushing prices up; see, for example, Barlevy, G. and Hu, L., “Unit Labor Costs and Inflation in the Non-Housing Service Sector”, Chicago Fed Letter, No 477, Federal Reserve Bank of Chicago, March 2023), the contribution of the wage-productivity differential is computed by summing the contributions from nominal wage growth (which has a positive coefficient in the model, as higher wages are passed through, to some extent, to consumer prices) and labour productivity (which has a negative coefficient in the model, as higher productivity lowers unit prices).
Producer prices relate to farm products and manufactured goods for the United States and to manufactured goods for the United Kingdom.
While not captured directly in the model, firms’ markups might also have played a role in the inflation surge, as evidenced for the United States in Gerinovics, R. and Metelli, L., “The evolution of firm markups in the US and implications for headline and core inflation”, VoxEU, Centre for Economic Policy Research, December 2023, and for the United Kingdom in Bunn, P., Anayi, L.S., Bloom, N., Mizen, P., Thwaites, G. and Yotzov, I., “Firming up Price Inflation”, NBER Working Paper, No 30505, National Bureau of Economic Research, September 2022.
See Yellen, J.L., “Inflation, Uncertainty, and Monetary Policy”, speech at the 59th Annual Meeting of the National Association for Business Economics, Board of Governors of the Federal Reserve System, 26 September 2017.
See Li, G. and Mulas-Granados, C., “The Recent Decline in United Kingdom Labor Force Participation: Causes and Potential Remedies”, IMF Selected Issues Papers, No 2023/051, International Monetary Fund, July 2023.
For the United Kingdom, the varying contribution from labour market slack to wage inflation since 2023 reflects volatility in the official unemployment rate, largely due to a strong decline in participation in the labour force survey. Meanwhile, vacancies have come down smoothly in the same period, consistent with easing pressures. Negative wage growth during the pandemic can be explained by the furlough scheme which was in place from March 2020 to September 2021 and led to lower earnings for some workers who were on furlough.
In the euro area, rents account for 13% of services inflation.
See the box entitled “Alternative cases for the persistence of domestic inflationary pressures” in Monetary Policy Report – November 2024, Bank of England, November 2024.