Last Tuesday’s UK labour market data was once again, at first sight, more than a little confusing. On the one hand, the Labour Force Survey of employment, produced by the ONS, showed total employment increased by about 90,000 in the three months to April compared with the previous three months.

On the other hand, payrolled employment fell by more than 100,000 over the same period and is estimated to have fallen further in May. Importantly, the number of people looking for work increased over the same period by about 100,000, the unemployment rate increased to 4.6%, and the number of job vacancies fell.

Moving to wages, the news was encouraging, especially for the Bank of England’s rate-setting committee, because average weekly earnings growth slowed to 5.25% over the three months to April and dipped in April to 4.5%. (Private sector wage settlements averaged about 4% in April).

So, what does all this data actually mean? On the face of it, it is slightly confusing because both employment and unemployment increased. The explanation is that while more people are in work, a greater number of people started looking for work, so the participation rate increased, and as a result, so did the unemployment rate. (The participation rate includes employed and unemployed people. Over the last twelve months, it has increased from 62.75% to 63.5%.)

In summary, the labour market has clearly softened a little over recent months as measured by the vacancy data, wage growth and unemployment. At an individual level, of course, this is not great news, but for the economy as a whole, it is positive news. I will try to explain why.

National Insurance increase

Back in October last year, the Chancellor announced a significant increase in the taxation of employment via a big increase in employers’ National Insurance. I said at the time that this was ill-advised and would have a number of effects on the economy. I wrote that increasing the cost of employment would lead to the substitution of capital for labour. This would in turn lead to two outcomes, one bad in the form of higher unemployment, which is what we are seeing now, and the second, given my view about a better performing economy, good, in the form of rising productivity which is what we will see later in the year as output continues to rise.

Productivity

The UK economy has had a relatively poor record on productivity, which I have written about in previous blogs. I am pretty confident that productivity has been understated in the UK for reasons I explained in Data vs Common Sense (March 17 2025), but nevertheless, it is often cited as a critical weakness in the economy. I have been less concerned about this for one clear reason. In the UK, we have a flexible labour market characterised by relatively low employment costs compared with other G7 countries with more rigid labour laws. This relative cost advantage has meant that businesses use more labour for a given level of output than businesses in peer economies. Hence, lower productivity here but also lower unemployment. The recently introduced increase in employers’ NI means this cost advantage has eroded. Consequently, businesses will start to substitute capital for labour, leading to better productivity. I believe we are now seeing this in the UK labour market data.

Inflationary pressure

A softening labour market will please the MPC because it will lead to lower wage growth (evident in the data) and ultimately reduce inflationary pressure in the economy. This should clear the way for more rate cuts this year and further cuts in 2026. (Resulting in a lower cost of capital)

Importantly, these data released on Tuesday last week do not indicate some kind of underlying deterioration in the UK economy. Not at all. Instead, they reflect the natural reaction of employers to relative price changes with respect to labour and capital. Looking forward, although April’s GDP data was a little weaker than the average of the last three months, the direction of travel for the UK economy is clear in my opinion. I am confident that the economy will strengthen through the remainder of 2025 and on into 2026 and that interest rates, which are clearly too high, will fall throughout this period. Fundamentally, I believe that lower savings, higher consumption spending, and higher investment spending will be the key drivers of a growing UK economy for the foreseeable future.