UK unemployment falls to seven-year low, but Bank is right to be cautious

Why is it that an economy that is creating jobs at a healthy rate has borrowing costs lower than at any time in the Bank’s history?

The last time Britain’s unemployment rate was as low as 5.5% was during the period of phoney calm between the run on Northern Rock and the collapse of Lehman Brothers. At that point, with the economy in the early stages of recession, official interest rates were 5%.

Over the past year, employment has grown by 564,000, with an additional 202,000 jobs created in the last three months alone. Yet interest rates stand at 0.5%, which is where they have been for the past six years. And, judging by the latest smoke signals from Threadneedle Street, the Bank of England has no intention of raising them any time soon.

Why is this? Why is it that an economy that is creating jobs at a healthy lick has borrowing costs lower than they have been in the Bank’s history, a level that was considered a temporary response to a dire calamity back in 2009?

The answer is that the UK economy has changed significantly since the pre-financial crisis days. When the jobless rate was last at 5.5%, wages were growing by around 4% a year, while today they are growing at about half that level. In spring 2008, productivity was improving by a bit more than 2% a year, in line with its historic trend. Productivity growth has been non-existent for the past three years and there has been no improvement in the economy’s efficiency since the recession began.

The weakness of investment is one reason productivity growth has been so poor, because workers are not using the latest kit. But the Bank points out in its quarterly inflation report that during the past two years employment growth has been concentrated in lower-skill occupations.

An increase in the supply of labour means employers have plenty of potential employees to choose from. Half the 568,000 increase in employment growth over the past year was accounted for by inward migration.

There are other factors. Low interest rates have allowed some firms to stay afloat that would otherwise have gone out of business. This may have prevented capital from flowing to more innovative companies. There is evidence that businesses have crimped on the development of the skills that make workers more productive.

The Bank’s view is that productivity will eventually recover and will return towards, – but remain below – pre-crisis rates of growth. It has to be said, however, that Threadneedle Street does not provide a particularly compelling explanation for why this should happen. It has been wrongly anticipating a pick-up in productivity for years.

Instead, a more likely path for the economy would appear to be that the UK’s strong employment record attracts more inward migration at the same time as the government’s social security cuts divert people from welfare into work. The supply of labour will remain strong, contrary to the Bank’s forecast, keeping the lid on wages and depressing productivity.

On Tuesday, some City analysts were pointing to the slight rise in the rate of earnings growth as a sign of increasing inflationary pressure from the labour market, but this has to be put into perspective. If you take average weekly earnings in the latest three months and compare them to the previous three months, wages are up by a solitary pound. That hardly constitutes a return to the 1970s.

To be fair to the Bank, it fully acknowledges that there is a great deal of uncertainty about what will happen to both wages and productivity. But it envisages that next year, there will be a return to the 4% earnings growth that prevailed before the storm broke. That 4% was split pretty much down the middle between 2% inflation and 2% productivity growth.

A return to those days looks a long way off. Core inflation (excluding energy, food and budget changes in excise duties) is running at 1% and productivity growth is zero. That explains why the Bank will, quite rightly, be cautious about tightening policy.


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