Economic Update: 23 June 2017

NAIRU AND QE REVERSAL

In the past few months we have heard a lot about the lack of wage growth in the US and the UK despite unemployment falling to levels that would normally start to push wages up. While wages have been rising, they have not been keeping pace with inflation which means that in real terms consumers have less to spend.

UK & US Real Wage Growth (Inflation Adjusted)

Source: UK Office for National Statistics & Bureau of Labor Statistics, 30 April 2017

To try and understand the relationship in the economy between levels of unemployment and wages, economists use a measure called NAIRU: short for the Non-Accelerating Inflation Rate of Unemployment.

Put simply, the economic theory goes something like this. As the economy recovers from recession, unemployment falls, i.e. the number of people employed goes up. At first the economic revival has only positive side effects. However, during the recovery, the pool of available workers reduces until a certain point where those in work feel confident enough about their job prospects to push for a wage rise and thereafter we begin to see economic growth accompanied by wage growth. This ultimately generates inflation which is addressed by a rise in interest rates to cool the economy.

NAIRU describes that early growth in the economy up to the point where unemployment has fallen but before inflation has set in. Historically, NAIRU, or the “natural” rate of unemployment has been about 5.5%-7% but in this economic cycle unemployment in the UK and United States is roughly 4.5% (see graph below) and still we are not seeing any major acceleration in wage growth either here or in the US.

UK & US Unemployment

Source: UK Office for National Statistics & Bureau of Labor Statistics, 30 April 2017

Now, it could be that this time is different. The measures introduced in the wake of the financial crisis in 2008 mean that this cycle is quite like no other. However, what is occupying policy makers is that this time may not be different, just slightly disorganised, and that despite UK wage growth being about 2.1% and below inflation of 2.9%, the cycle may be turning and it could be time to think about putting up interest rates.

In the UK, the Bank of England’s Monetary Policy Committee voted to leave rates on hold at 0.25% (having put through a cut shortly after the vote to leave the EU), but three of the eight members voted for a rise. In the US, not only did the Federal Reserve Board vote through an increase in rates from 0.75%/1.0% to 1.0/1.25% but it also announced that later this year it would begin to reverse the process of Quantitative Easing (QE) effectively selling back into the market the Treasury stocks and corporate bonds it has been buying for the last nine years.

Just as we were unsure of how QE would play out when it was introduced in 2008, so it is equally unclear how its reversal will affect markets when this next chapter in the great financial crisis unfolds later this year. Clearly policy makers are aware of the risks and therefore we are seeing a gradualist approach. The disagreement between Andrew Haldane, the Bank of England’s chief economist and Mark Carney, the Governor, in terms of when to raise interest rates is symptomatic of the difficult task of when to do so when traditional indicators like NAIRU fail to give a clear signal. What is evident is that even when rises do occur the pace will be slow, managed and even slower to feed through to savers. Regrettably, we know all too well that banks are very slow to pass on the full benefits of better savings rates to customers.

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