When UK unemployment was 7.7% in July 2013, Mark Carney, the newly arrived governor of the Bank of England, said that the Bank would probably have to rise interest rates when the unemployment rate dropped below 7%. Below that rate, it was expected that inflation would rise. In other words, 7% was the NAIRU – the non-accelerating rate of inflation. The most recent figure for the unemployment rate is 4.8% and yet the Bank of England has not raised interest rates. In fact, in response to the Brexit vote, it cut Bank Rate from 0.5% to 0.25% in August last year. (Click here for a PowerPoint of the chart below.)
The NAIRU is a similar, although not identical, concept to the natural rate of unemployment. The natural rate is the equilibrium rate consistent with an overall long-term balance of aggregate labour demand and supply: i.e. the rate after short-term cyclical movements in unemployment have been discounted. It is thus a long-term concept.
The NAIRU, although similar, focuses on the relationship between inflation and unemployment. With inflation caused solely by demand-side factors, the natural rate and the NAIRU will be similar if not identical. However, if cost-push factors change – say there is a poor harvest, which pushes up food prices and inflation (temporarily), or a substantial depreciation of the exchange rate caused by political factors (such as Brexit) – the NAIRU would increase, at least in the short term, as a higher rate of unemployment would be necessary to stop inflation rising. In the long term, although being defined differently, the NAIRU and the natural rate will be the same.
In practice, because the Bank of England is targeting inflation at a 24-month time horizon, the NAIRU for the UK at that point could also be seen as the natural rate.
So with the Bank of England not raising interest rates despite the considerable fall in the unemployment rate, does this imply a fall in the natural rate of unemployment? The answer is yes. The reason has to do with changes in the structure of the labour market.
The proportion of young people and women with children returning to the labour market has fallen. Such people have a higher-than-average rate of unemployment since they typically spend a period of time searching for a job.
Tax and benefit reforms over the years have increased the incentive for the unemployed to take work.
Perhaps the biggest factor is a greater flexibility in the labour market. As union power has waned and as people are increasingly working on flexible contracts, including zero-hour contracts, so this has moderated wage increases. At the same time, many firms are facing increased competition both from abroad and domestically via the Internet. This has put downward pressure on prices and hence on the wages firms are willing to pay.
The effect has been a fall in the NAIRU and probably the natural rate. Frictions in the labour market have reduced and people losing their jobs because of changes in industrial structure find it easier to get jobs in low-skilled service industries, where employers’ risks of taking on such workers have fallen because of the loss of rights for such workers.
So what is the natural rate of unemployment today? It is certainly much lower than 7%; the consensus is that it is probably below 5%. As Kristin Forbes, External MPC Member of the Bank of England stated in a recent speech:
[Unemployment] is forecast to increase gradually from its current 4.8% to a high of 5.0% in the second half of 2017, before falling back to its current rate by the end of 2019. To put this in context, 5.0% was previously believed to be around the UK’s natural rate of unemployment – the rate below which unemployment could not fall without wages picking up to levels inconsistent with sustaining inflation around the 2% target. Unemployment at 5.0% is also below the average unemployment rate for the UK over the pre-crisis period from 1997 to 2007 (when it was 5.5%).
She went on to discuss just what the figure is for the natural, or ‘equilibrium’, rate of unemployment (U*). One problem here is that there is considerable uncertainty over the figure in the current forecast made by the Bank.
[An] assumption in the forecast about which there is substantial uncertainty is of the equilibrium unemployment rate – or U* for short. Since I have been on the MPC, the Committee has assumed that U* was around 5%. This implied that the more by which unemployment exceeded 5%, the more slack existed in the economy, and the less upward momentum would be expected in wages (controlling for other factors, such as productivity growth).
As part of our annual assessment of regular supply-side conditions this January, Bank staff presented several pieces of analysis that suggested U* may be lower than 5% today [see, for example]. The majority of the MPC voted to lower our estimate of U* to 4.5%, based partly on the persistent weakness of wage growth over the past few years after accounting for other factors in our models. [See page 20 of the February 2017 Inflation Report.]
My own assessment, however, suggested that although U* was likely lower than 5% today, it is likely not as low as 4.5%. If true, this would suggest that there is less slack in the economy than in the MPC’s central forecast, and wage growth and inflation could pick up faster than expected.
Against that, however, uncertainty related to Brexit negotiations could make firms more cautious about raising wages, thereby dampening wage growth no matter where unemployment is relative to its equilibrium. Moreover, even if we could accurately measure the level of U* in the economy today, it could easily change over the next few years as the labour force adjusts to any changes in the movement of labour between the UK and European Union.
Determining the precise figure of the current natural rate of unemployment, and predicting it for the medium term, is very difficult. It involves separating out demand-side factors, which are heavily dependent on expectations. It also involves understanding the wage elasticity of labour supply in various markets and how this has been affected by the increased flexibility of these markets.
Articles
When will Britons get a pay rise? The Guardian, Phillip Inman (26/2/17)
BoE decision, Inflation Report – Analysts react DigitalLook, Alexander Bueso (2/2/17)
Bank of England hikes UK economic growth forecasts but warns of rising inflation The Telegraph, Szu Ping Chan (2/2/17)
Bank of England publications
Inflation Report Bank of England (February 2017)
A MONIAC (not manic) economy Bank of England Speeches, Kristin Forbes (8/2/17)
The labour market Bank of England Speeches, Michael Saunders (31/1/17)
Questions
- Distinguish between the following terms: natural rate of unemployment, NAIRU, equilibrium rate of unemployment, disequilibrium rate of unemployment.
- For what reasons did the Monetary Policy Committee members feel that the equilibrium rate of unemployment might be as low as 4.25%?
- Why might it be as high as 5%?
- How are changes in migration trends likely to affect (a) wage growth and (b) unemployment?
- How is the amount of slack in an economy measured? What impact does the degree of slack have on wage growth and inflation?
- What is meant by the ‘gig’ economy? How has the development of the gig economy impacted on unemployment and wages?
- Why has there been a considerable rise in self employment?
- How may questions of life style choice and control over the hours people wish to work impact on the labour market?
- If people are moving jobs less frequently, does this imply that the labour market is becoming less flexible?
- Why may firms in the current climate be cautious about raising wages even if aggregate demand picks up?
Both the financial and goods markets are heavily influenced by sentiment. And such sentiment tends to be self-reinforcing. If consumers and investors are pessimistic, they will not spend and not invest. The economy declines and this further worsens sentiment and further discourages consumption and investment. Banks become less willing to lend and stock markets fall. The falling stock markets discourage people from buying shares and so share prices fall further. The despondency becomes irrational and greatly exaggerates economic fundamentals.
This same irrationality applies in a boom. Here it becomes irrational exuberance. A boom encourages confidence and stimulates consumer spending and investment. This further stimulates the boom via the multiplier and accelerator and further inspires confidence. Banks are more willing to lend, which further feeds the expansion. Stock markets soar and destabilising speculation further pushes up share prices. There is a stock market bubble.
But bubbles burst. The question is whether the current global stock market boom, with share prices reaching record levels, represents a bubble. One indicator is the price/earnings (PE) ratio of shares. This is the ratio of share prices to earnings per share. Currently the ratio for the US index, S&P 500, is just over 26. This compares with a mean over the past 147 years of 15.64. The current ratio is the third highest after the peaks of the early 2000s and 2008/9.
An alternative measure of the PE ratio is the Shiller PE ratio (see also). This is named after Robert Shiller, who wrote the book Irrational Exuberance. Unlike conventional PE ratios, which only look at average earnings over the past four quarters, the Shiller PE ratio uses average earnings over the past 10 years. “Because this factors in earnings from the previous ten years, it is less prone to wild swings in any one year.”
The current level of the Shiller PE ratio is 29.14, the third highest on record, this time after the period running up to the Wall Street crash of 1929 and the dot-com bubble of the late 1990s. The mean Shiller PE ratio over the past 147 years is 16.72.
So are we in a period of irrational exuberance? And are stock markets experiencing a bubble that sooner or later will burst? The following articles explore these questions.
Articles
2 Clear Instances of Irrational Exuberance Seeking Alpha, Jeffrey Himelson (12/2/17)
Promised land of Trumpflation-inspired global stimulus has been slow off the mark South China Morning Post, David Brown (20/2/17)
A stock market crash is a way off, but this boom will turn to bust The Guardian, Larry Elliott (16/2/17)
The “boring” bubble is close to bursting – the Unilever bid proves it MoneyWeek, John Stepek (20/2/17)
Questions
- Find out what is meant by Minksy’s ‘financial instability hypothesis’ and a ‘Minsky moment’. How might they explain irrational exuberance and the sudden turning point from a boom to a bust?
- Is it really irrational to buy shares with a very high PE ratio if everyone else is doing so?
- Why are people currently exuberant?
- What might cause the current exuberance to end?
- How does irrational exuberance affect the size of the multiplier?
- How might the behaviour of banks and other financial institutions contribute towards a boom fuelled by irrational exuberance?
- Compare the usefulness of a standard PE ratio with the Shiller PE ratio.
- Other than high PE ratios, what else might suggest that stock markets are overvalued?
- Why might a company’s PE ratio differ from its price/dividends ratio (see)? Which is a better measure of whether or not a share is overvalued?
Many politicians throughout the world,
not just on the centre and left, are arguing for increased spending on infrastructure. This was one of the key proposals of Donald Trump during his election campaign. In his election manifesto he pledged to “Transform America’s crumbling infrastructure into a golden opportunity for accelerated economic growth and more rapid productivity gains”.
Increased spending on inffrastructure has both demand- and supply-side effects.
Unless matched by cuts elsewhere, such spending will increase aggregate demand and could have a high multiplier effect if most of the inputs are domestic. Also there could be accelerator effects as the projects may stimulate private investment.
On the supply side, well-targeted infrastructure spending can directly increase productivity and cut costs of logistics and communications.
The combination of the demand- and supply-side effects could increase both potential and actual output and reduce unemployment.
So, if infrastructure projects can have such beneficial effects, why are politicians often so reluctant to give them the go-ahead?
Part of the problem is one of timing. The costs occur in the short run. These include demolition, construction and disruption. The direct benefits occur in the longer term, once the project is complete. And for complex projects this may be many years hence. It is true that demand-side benefits start to occur once construction has begun, but these benefits are widely dispersed and not easy to identify directly with the project.
Then there is the problem of externalities. The external costs of projects may include environmental costs and costs to local residents. This can lead to protests, public hearings and the need for detailed cost–benefit analysis. This can delay or even prevent projects from occurring.
The external benefits are to non-users of the project, such as a new bridge or bypass reducing congestion for users of existing routes. These make the private construction of many projects unprofitable, except with public subsidies or with public–private partnerships. So there does need to be a macroeconomic policy that favours publicly-funded infrastructure projects.
One type of investment that is less disruptive and can have shorter-term benefits is maintenance investment. Maintenance expenditure can avoid much more costly rebuilding expenditure later on. But this is often the first type of expenditure to be cut when public-sector budgets as squeezed, whether at the local or national level.
The problem of lack of infrastructure investment is very much a political problem. The politicians who give the go-ahead to such projects, such as high-speed rail, come in for criticisms from those bearing the short-run costs but they are gone from office once the benefits start to occur. They get the criticism but not the praise.
Articles
Are big infrastructure projects castles in the air or bridges to nowhere? The Economist, Buttonwood’s notebook (16/1/17)
Trump’s plans to rebuild America are misguided and harmful. This is how we should do it. The Washington Post, Lawrence H. Summers (17/1/17)
Questions
- Identify the types of externality from (a) a new high-speed rail line, (b) new hospitals.
- How is discounting relevant to decisions about public-sector projects?
- Why are governments often unwilling to undertake (a) new infrastructure projects, (b) maintenance projects?
- Is a programme of infrastructure investment necessarily a Keynesian policy?
- What accelerator effects would you expect from infrastructure investment?
- Explain the difference between the ‘spill-out’ and ‘pull-in’ effects of different types of public investments in a specific location. Is it possible for a project to have both effects?
- What answer would you give to the teacher who asked the following question of US Treasury Secretary, Larry Summers? “The paint is chipping off the walls of this school, not off the walls at McDonald’s or the movie theatre. So why should the kids believe this society thinks their education is the most important thing?”
- What is the ‘bridge to nowhere’ problem? Why does it occur and what are the solutions to it?
- Why is the ‘castles in the air’ element of private projects during a boom an example of the fallacy of composition?
Household borrowing on credit cards and through overdrafts and loans has been growing rapidly. This ‘unsecured’ borrowing is now rising at rates not seen since well before the credit crunch of 2008 (click here for a PowerPoint of the chart below). Should this be a cause for concern?
Household confidence is generally high and, as a result, people continue to take out more loans and so household debt continues to increase. Saving rates are falling and, at 5.1% of household disposable income, are the lowest rate since 2008, mirroring the high levels of spending and borrowing.
But as long as the economy keeps growing and as long as interest rates stay at record low levels, people should be able to continue servicing this rising debt. Indeed, with generous balance transfer offers between credit cards and many people paying off their full balance each month, only 56.6% are paying any interest at all on credit card debt, the lowest level on record.
But there could be trouble ahead! Secured borrowing (i.e. on mortgages) is at record highs as house prices have soared, limiting the amount people have to left to spend, even with ultra low interest rates. Student debt is growing, putting a brake on graduate spending.
With economic growth set to slow and inflation set to rise as the effects of the lower pound filter through into retail prices, this could initially boost borrowing further as people seek to maintain levels of consumption. But then, if unemployment starts to rise and consumer confidence starts to fall, real spending could decline, putting further downward pressure on the economy.
Confidence could then fall further and we could witness a repeat of 2008–9, when people became worried about their levels of borrowing and cut back on consumption in an attempt to claw down their debt. The economy was pushed into recession.
The Bank of England is well aware of this scenario and wants banks to ensure that their customers can afford loans before offering them.
Articles
Bank governor Mark Carney warns on household debt BBC News, Brian Milligan (30/11/16)
Credit crunch: Household debt is rising just as the economy’s future is uncertain The Telegraph, Tim Wallace (10/12/16)
Bank of England publication
Financial Stability Report, November 2016 Bank of England (30/11/16)
Data
Money and lending Bank of England Interactive Database
United Kingdom Households Debt To GDP Trading Economics
Household debt OECD Data
Questions
- What determines the amount people borrow?
- What would cause people to cut back on the amount of debt they have?
- Distinguish between secured and unsecured borrowing and debt.
- Why has secured borrowing risen? Does this matter?
- What is meant by the term ‘re-leveraging’? What is its significance in terms of household borrowing?
- Find out what the affordability tests are for anyone wanting to take out a mortgage.
- What are the greatest risks to UK financial stability?
On 14 December, the US Federal Reserve announced that its 10-person Federal Open Market Committee (FOMC) had unanimously decided to raise the Fed’s benchmark interest rate by 25 basis points to a range of between 0.5% and 0.75%. This is the first rise since this time last year, which was the first rise for nearly 10 years.
The reasons for the rise are two-fold. The first is that the US economy continues to grow quite strongly, with unemployment edging downwards and confidence edging upwards. Although the rate of inflation is currently still below the 2% target, the FOMC expects inflation to rise to the target by 2018, even with the rate rise. As the Fed’s press release states:
Inflation is expected to rise to 2% over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.
The second reason for the rate rise is the possible fiscal policy stance of the new Trump administration. 
If, as expected, the new president adopts an expansionary fiscal policy, with tax cuts and increased government spending on infrastructure projects, this will stimulate the economy and put upward pressure on inflation. It could also mean that the Fed will raise interest rates again more quickly. Indeed, the FOMC indicated that it expects three rate rises in 2017 rather than the two it predicted in September.
However, just how much and when the Fed will raise interest rates again is highly uncertain. Future monetary policy measures will only become more predictable when Trump’s policies and their likely effects become clearer.
Articles
US Federal Reserve raises interest rates and flags quicker pace of tightening in 2017 Independent, Ben Chu (14/12/16)
US Federal Reserve raises interest rates: what happens next? The Telegraph, Szu Ping Chan (15/12/16)
Holiday traditions: The Fed finally manages to lift rates in 2016 The Economist (14/12/16)
US raises key interest rate by 0.25% on strengthening economy BBC News (14/12/16)
Fed Raises Key Interest Rate, Citing Strengthening Economy The New York Times, Binyamin Appelbaum (14/12/16)
US dollar surges to 14-year high as Fed hints at three rate hikes in 2017 The Guardian, Martin Farrer and agencies (15/12/16)
Questions
- What determines the stance of US monetary policy?
- How does fiscal policy impact on market interest rates and monetary policy?
- What effect does a rise in interest rates have on exchange rates and the various parts of the balance of payments?
- What effect is a rise in US interest rates likely to have on other countries?
- What is meant by ‘forward guidance’ in the context of monetary policy? What are the benefits of providing forward guidance?
- What were the likely effects on the US stock market of the announcement by the FOMC?
- Following the FOMC announcement, two-year US Treasury bond yields rose to 1.231%, the highest since August 2009. Explain why.
- For what reason does the FOMC believe that the US economy is already expanding at roughly the maximum sustainable pace?
When UK unemployment was 7.7% in July 2013, Mark Carney, the newly arrived governor of the Bank of England, said that the Bank would probably have to rise interest rates when the unemployment rate dropped below 7%. Below that rate, it was expected that inflation would rise. In other words, 7% was the NAIRU – the non-accelerating rate of inflation. The most recent figure for the unemployment rate is 4.8% and yet the Bank of England has not raised interest rates. In fact, in response to the Brexit vote, it cut Bank Rate from 0.5% to 0.25% in August last year. (Click here for a PowerPoint of the chart below.)
The proportion of young people and women with children returning to the labour market has fallen. Such people have a higher-than-average rate of unemployment since they typically spend a period of time searching for a job.
The effect has been a fall in the NAIRU and probably the natural rate. Frictions in the labour market have reduced and people losing their jobs because of changes in industrial structure find it easier to get jobs in low-skilled service industries, where employers’ risks of taking on such workers have fallen because of the loss of rights for such workers.
