UK Bank Rate: Slackers hold the key

The performance of the UK labour market over the past year or so has confounded all expectations. And today’s data showed a further drop in the unemployment rate, to just 6.4% in the three months to June. Just one year ago the Bank of England was forecasting that unemployment would now be more than a percentage point above its current level. And it was no surprise that today’s Inflation Report saw it revise down significantly its unemployment forecast for the fourth quarter in a row.

Unemployment and the Bank’s forecast

UK Bank Rate: Slackers - UnemploymentSource: Datastream, Bank of England and Daiwa Capital Markets Europe Ltd.

But the drop in the unemployment rate has not been accompanied, in the official data at least, by any upward pressure on earnings. Indeed, today’s data also showed average regular earnings up just 0.6%3M/Y, the weakest growth since the series began in 2001 and a rate that, in the medium term, would deliver an undershooting of the inflation target.  

But as the chart below, taken from today’s Inflation Report, shows, the official data have been at odds with what some surveys have been suggesting. Some surveys have pointed to a rapidly tightening labour market and upward pressure on wages. The CBI’s quarterly services survey, for instance, suggested that the balance of employers reporting an increase in wages in Q214 was at its highest for almost six years. The REC/KPMG jobs market survey, meanwhile, suggested that the availability of staff is now at its lowest since the survey began in 1998 and that starting salaries in permanent roles were growing at a record high in June. All grist to the mill for MPC members worried about looming wage increases. But other surveys that ask employers to quantify pay increases tell a very different story. For example, the CIPD’s latest labour market survey suggested that, of those firms planning a basic pay increase, the expected median wage growth in the twelve months to May 2015 was just 2%, chiming with the BoE’s Agents’ survey that suggested the majority of pay settlements remained moderate in the range of 2-3%.

Average earnings growth and wage surveys

UK Bank Rate: Slackers - EarningsSource: Bank of England 

For MPC members, therefore, understanding why wage growth has been so weak, and whether it will remain subdued, is the key question in setting policy. And today’s Inflation Report told us that the majority of MPC members believe that weak wage growth is primarily a function of structural changes in the labour market. In particular, having estimated just one year ago that the medium-term equilibrium rate of unemployment was 6½%, the recent performance of the labour market has led the MPC to revise that estimate down to 5½%, implying continued significant slack in the labour market. And, reflecting that, while the MPC believes that spare capacity has been used up faster than anticipated in May, it believes it underestimated the degree of spare capacity at that time. So, it now believes that there is still around 1% of spare capacity in the economy.

The change in view on the equilibrium unemployment rate, coupled with persistently weak average earnings data, unsurprisingly led to a large downward revision to the Bank’s projection for unit wage cost growth. Indeed, they are now expected to fall this year, and be weaker than expected in May right across the forecast period – for most members of the Committee, therefore, wage pressures have diminished and are expected to remain diminished even against the backdrop of an unemployment forecast that sees the rate a whole half a percentage point lower than expected in May by 2016, at 5.4%.

Given all of this, and notwithstanding the fact that GDP growth has been stronger than expected in May, and is expected to remain slightly stronger than expected, Mark Carney was able to stick to his mantra that increases in Bank Rate, when they come, will be very gradual, and that the eventual resting point for Bank Rate will be significantly below what had been usual in the pre-crisis period. So, while an increase in Bank Rate in November remains likely (and the release of the minutes of the August MPC meeting next week will provide more information on that), with Carney emphasising that market expectations of 15bps of tightening each quarter thereafter are fully consistent with the MPC’s forecasts, which see inflation within target throughout the coming two years, the clear message is that Bank Rate, while set to rise, will do so only very slowly.

But, as Carney also acknowledged, it’s not just about the interaction between unemployment and wages that will determine the degree of inflation pressures from the labour market - what happens to productivity growth is also key. Pre-crisis, the MPC’s rule of thumb was that 4½%Y/Y growth in wages was broadly consistent with its 2% inflation target (2% inflation plus 2½% trend growth). But so far in the current recovery there has been virtually no growth in productivity. If that were to continue, then a much lower level of average earnings growth (of around 2%Y/Y) would be consistent with a 2% inflation target. But even the most pessimistic MPC member doesn’t believe that we won’t eventually get some pick up in productivity. And while the Bank revised down its forecast for productivity growth right across its forecast horizon, it still expects a meaningful improvement by 2016. 

Indeed, even the anticipated 1¾% growth productivity in 2016 would be below the long-run average and Carney indicated today that he did not believe that there had been a permanent reduction in productivity growth. As such if productivity growth picks up more quickly than anticipated, an entirely plausible outcome given that it was remarkably stable for many years ahead of the financial crisis, that should also imply fewer concerns about inflationary pressures from the labour market. Against that backdrop, the MPC might find itself needing to raise rates even less quickly than the current snail’s pace it is indicating.

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