A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK. Subscribe to & view previous editions at: http://blogs.deloitte.co.uk/mondaybriefing/

To the bafflement of economists Britain’s economic recovery has been accompanied by growing demand for labour and falling wages. Since 2007 the number of people in work in the UK has risen by 2.7 million, an increase of 9%. Over the same time earnings, after allowing for inflation, have fallen by about 2.5%.

The so-called Phillips Curve, which assumes a relationship between unemployment, wages and inflation, seems to have broken down. The US has also seen the relationship between labour demand and wages weaken.

Economic uncertainty and different forms of work, including the growth of self-employment and part-time work, have dampened wage and inflation pressures. The relationship between labour supply and demand may have changed, but recent data suggest it has not been destroyed.

In the wake of the financial crisis the number of people moving from one job to another fell sharply as employees reacted to uncertainty by staying put. Today low unemployment and plentiful job vacancies have increased the incentives to change jobs in search of pay rises and seniority. In a powerful sign of growing wage pressures so called job-to-job flows are running at the highest level in 17-years in the UK. It is much the same story in the US.

Last week the Bank of England reported that employers were facing widespread recruitment difficulties, with skills shortages broadening from construction, engineering, software development and professional services and logistics to hospitality, warehousing, agriculture and food. The Bank noted that growing skills shortages reflected a diminishing availability of EU migrant labour.

This represents a big change. For the last two decades employers have been able to count on a strong supply of workers coming to the UK from overseas, and increasingly from the EU.

2.7 million more people are in employment in the UK today than in 2007 of whom 45% are EU-born, mainly from the Central European nations, 32% are from outside Europe and 23% are UK-born. Immigration has played a major role in meeting increased labour demand in the last decade.

But a weaker pound and Brexit-related uncertainties seem to have dimmed the appeal of the UK to EU workers. The annual rate of growth of the UK’s EU-born workforce slowed to just under 4% at the end of last year after a decade and a half of growth averaging around 12%.

A historically low unemployment rate, coupled with new barriers to EU migration, represent a step change in labour supply. Wage pressures seem likely to mount. The Bank of England reports that UK employers expect pay rises to average 3.1% this year, up from 2.6% in 2017. This will be good news for consumers, but a challenge for employers.

The question is whether rising labour costs will be financed by productivity growth or whether margins will be squeezed, and jobs lost. The theory that sluggish wage growth has contributed to an inefficient use of labour, and low productivity, is about to be tested.