The Trade-Off: National Living Wage Increases and Inflationary Pressure
The UK’s policy of aggressively increasing the National Living Wage (NLW) is fundamentally about redistributing wealth and addressing in-work poverty. By committing to a target of two-thirds of median earnings, the government has ensured significant real-terms pay increases for the lowest earners. However, in macroeconomic terms, an increase in the legal pay floor is a mandated rise in the cost of labour, which introduces a direct channel for cost-push inflation . The core challenge for the Low Pay Commission (LPC) and the Bank of England is to manage this cost shock without triggering a sustained, self-perpetuating wage-price spiral.
The Mechanisms of Inflationary Pass-Through
The immediate impact of a higher NLW is felt by businesses, who have three primary mechanisms to absorb the increased payroll costs, one of which is inflation. First, some firms, especially those with high profit margins or market power, can absorb the cost through reduced profits. Second, firms can seek to improve labour productivity by investing in new technology, streamlining operations, or offering better training, which mitigates the cost increase by generating more output per hour. Third, and most controversially, they can pass the cost onto the consumer by raising prices. Empirical evidence suggests that for every 10% increase in the minimum wage, prices in the most-affected sectors, such as hospitality and retail, are expected to rise by approximately 0.2% to 1.1%. This pass-through is not instantaneous but tends to be concentrated in the months immediately following the annual uprating.
The Concentrated Sectoral Inflation Effect
The impact on overall, headline inflation is generally small because the minimum wage primarily affects a concentrated group of low-wage industries. However, for specific consumer goods and services, the effect is much more pronounced. Sectors that are highly labour-intensive and have little scope for automation bear the brunt of the cost increase and are therefore most likely to raise prices. This is why prices for domestic services, take-away meals, and hotel/canteen services tend to rise faster than the average. This localized, sector-specific inflation is a necessary consequence of the minimum wage policy; without it, many low-margin businesses would simply become economically unviable and would be forced to close, leading to job losses (disemployment).
The Risk of a Wage-Price Spiral and Spillovers
A major concern for the Bank of England is the risk of wage spillover and the subsequent triggering of a systemic wage-price spiral. As the NLW rises significantly, the pay differential between minimum-wage workers and those slightly above them (e.g., experienced supervisors or mid-level staff) narrows, a phenomenon known as wage compression. To maintain internal equity and morale, employers are often forced to raise the wages of the higher-paid, non-NLW staff as well. This “ripple effect” pushes wage inflation up the earnings distribution. If this broad wage growth outpaces overall productivity growth, it places persistent upward pressure on prices across the economy. Once employees across the board start demanding higher pay rises simply to compensate for the higher inflation they are experiencing, the spiral is set in motion, making the central bank’s job of achieving its 2% inflation target much harder.
The Policy Balancing Act and Real-Terms Gain
Despite these inflationary pressures, the current NLW strategy has been successful in achieving its primary social goal: delivering a significant real-terms increase in pay for the lowest earners. The Low Pay Commission is tasked with finding the “sweet spot”—the highest possible minimum wage that does not lead to significant disemployment. By explicitly incorporating future inflation forecasts and the broader macroeconomic context into its recommendations, the LPC is attempting to manage the inflationary risk proactively. In recent years, the rapid increases were essential to ensure low-paid workers were protected from the peak cost-of-living crisis. Ultimately, the price increases generated by the NLW are seen by policymakers as a justifiable cost—a minor structural increase in price levels—in exchange for a major social benefit in the form of reduced poverty and greater wage equality for millions of workers.
