The last two weeks have been quite busy for macroeconomists, HM Treasury staff and statisticians in the UK. The Chancellor of the Exchequer, Mr Phillip Hammond, delivered his (fairly upbeat) Spring Budget Statement on 13 March, highlighting among other things the ‘stellar performance’ of UK labour markets. According to a Treasury Press Release:
Employment has increased by 3 million since 2010, which is the equivalent of 1,000 people finding work every day. The unemployment rate is close to a 40-year low. There is also a joint record number of women in work – 15.1 million. The OBR predict there will be over 500,000 more people in work by 2022.
To put these figures in perspective, according to recent ONS estimates, in January 2018 the rate of UK unemployment was 4.3 per cent – down from 4.4 per cent in December 2017. This is the lowest it has been since 1975. This is of course good news: a thriving labour market is a prerequisite for a healthy economy and a good sign that the UK is on track to full recovery from its 2008 woes.
The Bank of England welcomed the news with a mixture of optimism and relief, and signalled that the time for the next interest rate hike is nigh: most likely at the next MPC meeting in May.
But what is the practical implication of all this for UK consumers and workers?
For workers it means it’s a ‘sellers’ market’: as more people get into employment, it becomes increasingly difficult for certain sectors to fill new vacancies. This is pushing nominal wages up. Indeed, UK wages increased on average by 2.6 per cent year-to-year.
In real terms, however, wage growth has not been high enough to outpace inflation: real wages have fallen by 0.2 per cent compared to last year. Britain has received a pay rise, but not high enough to compensate for rising prices. To quote Matt Hughes, a senior ONS statistician:
Employment and unemployment levels were both up on the quarter, with the employment rate returning to its joint highest ever. ‘Economically inactive’ people — those who are neither working nor looking for a job — fell by their largest amount in almost five and a half years, however. Total earnings growth continues to nudge upwards in cash terms. However, earnings are still failing to outpace inflation.
An increase in interest rates is likely to put further pressure on indebted households. Even more so as it coincides with the end of the five-year grace period since the launch of the 2013 Help-to-Buy scheme, which means that many new homeowners who come to the end of their five year fixed rate deals, will soon find themselves paying more for their mortgage, while also starting to pay interest on their Help-to-buy government loan.
Will wages grow fast enough in 2018 to outpace inflation (and despite Brexit, which is now only 12 months away)? We shall see.
Data, Reports and Analysis
- What is monetary policy, and how is it used to fine tune the economy?
- What is the effect of an increase in interest rates on aggregate demand?
- How optimistic (or pessimistic) are you about the UK’s economic outlook in 2018? Explain your reasoning.
In the last blog post, As UK inflation rises, so real wages begin to fall, we showed how the rise in inflation following the Brexit vote is causing real wages in the UK to fall once more, after a few months of modest rises, which were largely due to very low price inflation. But how does this compare with other OECD countries?
In an article by Rui Costa and Stephen Machin from the LSE, the authors show how, from the start of the financial crisis in 2007 to 2015 (the latest year for which figures are available), real hourly wages fell further in the UK than in all the other 27 OECD countries, except Greece (see the chart below, which is Figure 5 from their article). Indeed, only in Greece, the UK and Portugal were real wages lower in 2015 than in 2007.
The authors examine a number of aspects of real wages in the UK, including the rise in self employment, differences by age and sex, and for different percentiles in the income distribution. They also look at how family incomes have suffered less than real wages, thanks to the tax and benefit system.
The authors also look at what the different political parties have been saying about the issues during their election campaigns and what they plan to do to address the problem of falling, or only slowly rising, real wages.
Real Wages and Living Standards in the UK LSE – Centre for Economic Performance, Rui Costa and Stephen Machin (May 2017)
The Return of Falling Real Wages LSE – Centre for Economic Performance, David Blanchflower, Rui Costa and Stephen Machin (May 2017)
The chart that shows UK workers have had the worst wage performance in the OECD except Greece Independent, Ben Chu (5/6/17)
Earnings and working hours ONS
International comparisons of productivity ONS
- Why have real wages fallen more in the UK than in all OECD countries except Greece?
- Which groups have seen the biggest fall in real wages? Explain why.
- What policies are proposed by the different parties for raising real wages (a) generally; (b) for the poorest workers?
- How has UK productivity growth compared with that in other developed countries? What explanations can you offer?
- What is the relationship between productivity growth and the growth in real wages?
With the effects of the depreciation of sterling feeding through into higher prices, so the rate of inflation has risen. The latest figures from the ONS show that in the year to April 2017, CPI inflation was 2.7% – up from 2.3% in the year to March. The largest contributors to higher prices were transport costs and housing and household services.
But wage increases are not keeping up with price increases. In 2017 Q1, the average annual growth rate in regular pay (i.e. excluding bonuses) was 2.1%. In other words, real pay is falling. And this is despite the fact that the unemployment rate, at 4.6%, is the lowest since 1975.
The fall in real wages is likely to act as a brake on consumption and the resulting dampening of aggregate demand could result in lower economic growth. On the other hand, the more buoyant world economy, plus the lower sterling exchange rate is helping to boost exports and investment and this could go some way to offsetting the effects on consumption. As Mark Carney stated in his introductory remarks to the May 2017 Bank of England Inflation Report:
The combination of the stronger global outlook and sterling’s past depreciation is likely to support UK net trade. And together with somewhat lower uncertainty, stronger global growth is also likely to encourage investment as exporters renew and increase capacity.
According to the Bank of England, the net effect will be modest economic growth, despite the fall in real wages.
In the MPC’s central forecast, quarterly growth is forecast to stabilise around its current rate, resulting in growth of 1.9% in 2017 and around 1¾% in each of the next two years.
But forecasting is dependent on a range of assumptions, not least of which are assumptions about consumer and business expectations. These, in turn, depend on a whole range of factors, such as the outcome of the UK election, the Brexit negotiations, commodity prices, world growth rates and international events, such as the actions of Donald Trump. Because of the uncertainty surrounding forecasts, the Bank of England uses fan charts. In the two fan charts illustrated below (from the May 2017 Inflation Report), the bands on constructed on the following assumptions:
If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that CPI inflation or the mature estimate of GDP growth would lie within the darkest central band on only 30 of those occasions and within each pair of the lighter coloured areas on 30 occasions.
The charts and tables showing the May 2017 projections have been conditioned on the assumptions that the stock of purchased gilts remains at £435 billion and the stock of purchased corporate bonds remains at £10 billion throughout the forecast period, and on the Term Funding Scheme (TFS); all three of which are financed by the issuance of central bank reserves. They have also been conditioned on market interest rates, unless otherwise stated.
The wider the fan, the greater the degree of uncertainty. These fan charts are wide by historical standards, reflecting the particularly uncertain future for the UK economy.
But one thing is clear from the latest data: real incomes are falling. This is likely to dampen consumer spending, but just how much this will impact on aggregate demand over the coming months remains to be seen.
UK real wages drop for first time in three years Financial Times, Sarah O’Connor (17/5/17)
Bank of England warns Brexit vote will damage living standards The Guardian, Katie Allen (11/5/17)
UK wage growth lags inflation for first time since mid-2014 BBC News (17/5/17)
Britons’ Falling Real Wages Show Challenging Times Have Arrived Bloomberg, Scott Hamilton and Lucy Meakin (17/5/17)
Jobs market will suffer a Brexit slowdown, say experts The Guardian, Angela Monaghan and Phillip Inman (15/5/17)
Pay will continue to be squeezed, employers’ survey suggests BBC News, Kamal Ahmed (15/5/17)
Brexit latest: Real wages falling, Office for National Statistics reveals Independent, Ben Chu (17/5/17)
UK inflation climbs to four-year high, beating forecasts Financial Times, Gavin Jackson (16/5/17)
Why is UK inflation at a four-year high? Financial Times, Gavin Jackson (19/5/17)
A blip, or a test of hawks’ patience? Economists respond to high UK inflation data Financial Times, Nicholas Megaw (16/5/17)
UK inflation rate at highest level since September 2013 BBC News (16/5/17)
Inflation jumps to its highest level since 2013 as Brexit continues to bite Business Insider, Will Martin (16/5/17)
UK GDP growth weaker than expected as inflation hits spending The Guardian, Katie Allen (25/5/17)
UK economic growth estimate revised down BBC News (25/5/17)
Inflation Report, May 2017 Bank of England (11/5/17)
Labour Market Outlook, Sping 2017 Chartered Institute of Personnel and Development (May 2017)
Statistical Interactive Database – interest & exchange rates data Bank of England
Inflation and price indices ONS
Earnings and working hours ONS
Second estimate of GDP: Jan to Mar 2017 ONS Statistical Bulletin (25/5/17)
- Find out what has happened to the dollar/sterling and the euro/sterling exchange rate and the sterling exchange rate index over the past 24 months. Plot the data on a graph.
- Explain the changes in these exchange rates.
- Why is there negative real wage growth in the UK when the rate of unemployment is the lowest it’s been for more than 40 years?
- Find out what proportion of aggregate demand is accounted for by household consumption. Why is this significant in understanding the likely drivers of economic growth over the coming months?
- Why is uncertainty over future UK growth rates relatively high at present?
- Why is inflation likely to peak later this year and then fall?
- What determines the size and shape of the fan in a fan chart?
According to the theory of the political business cycle, governments call elections at the point in the business cycle that gives them the greatest likelihood of winning. This is normally near the peak of the cycle, when the economic news is currently good but likely to get worse in the medium term. With fixed-term governments, this makes it harder for governments as, unless they are lucky, they have to use demand management policies to engineer a boom as an election approaches. It is much easier if they can choose when to call an election.
In the UK, under the Fixed-term Parliaments Act of 2011, the next election must be five years after the previous one. This means that the next election in the UK must be the first Thursday in May 2020. The only exception is if at least two-thirds of all MPs vote for a motion ‘That there shall be an early parliamentary general election’ or ‘That this House has no confidence in Her Majesty’s Government.’
The former motion was put in the House of Commons on 19 April and was carried by 522 votes to 13 – considerably more than two-thirds of the 650 seats in Parliament. The next election will therefore take place on the government’s chosen date of 8 June 2017.
Part of the reason for the government calling an election is to give it a stronger mandate for its Brexit negotiations. Part is to take advantage of its currently strong opinion poll ratings, which, if correct, will mean that it will gain a substantially larger majority. But part could be to take advantage of the current state of the business cycle.
Although the economy is currently growing quite strongly (1.9% in 2016) and although forecasts for economic growth this year are around 2%, buoyed partly by a strongly growing world economy, beyond that things look less good. Indeed, there are a number of headwinds facing the economy.
First there are the Brexit negotiations, which are likely to prove long and difficult and could damage confidence in the economy. There may be adverse effects on both inward and domestic investment and possible increased capital outflows. At the press conference to the Bank of England’s February 2017 Inflation Report, the governor stated that “investment is expected to be around a quarter lower in three years’ time than projected prior to the referendum, with material consequences for productivity, wages and incomes”.
Second, the fall in the sterling exchange rate is putting upward pressure on inflation. The Bank of England forecasts that CPI inflation will peak at around 2.8% in early 2018. With nominal real wages lagging behind prices, real wages are falling and will continue to do so. As well as from putting downward pressure on living standards, it will tend to reduce consumption and the rate of economic growth.
Consumer debt has been rising rapidly in recent months, with credit-card debt reaching an 11-year high in February. This has helped to support growth. However, with falling real incomes, a lack of confidence may encourage people to cut back on new borrowing and hence on spending. What is more, concerns about the unsustainability of some consumer debt has encouraged the FCA (the financial sector regulator) to review the whole consumer credit industry. In addition, many banks are tightening up on their criteria for granting credit.
Retail spending, although rising in February itself, fell in the three months to February – the largest fall for nearly seven years. Such falls are likely to continue.
So if the current boom in the economy will soon end, then, according to political business cycle theory, the government is right to have called a snap election.
Gloomy economic outlook is why Theresa May was forced to call a snap election The Conversation, Richard Murphy (18/4/17)
What does Theresa May’s general election U-turn mean for the economy? Independent, Ben Chu (18/4/17)
It’s not the economy, stupid – is it? BBC News Scotland, Douglas Fraser (18/4/17)
Biggest fall in UK retail sales in seven years BBC News (21/4/17)
Sharp drop in UK retail sales blamed on higher prices Financial Times, Gavin Jackson (21/4/17)
Shoppers cut back as inflation kicks in – and top Bank of England official says it will get worse The Telegraph, Tim Wallace Szu Ping Chan (21/4/17)
Retail sales volumes fall at fastest quarterly rate in seven years Independent, Ben Chu (21/4/17)
Retail sales in Great Britain: Mar 2017 ONS (21/4/17)
- For what reasons might economic growth in the UK slow over the next two to three years?
- For what reasons might economic growth increase over the next two to three years?
- Why is forecasting UK economic growth particularly difficult at the present time?
- What does political business cycle theory predict about the behaviour of governments (a) with fixed terms between elections; (b) if they can choose when to call an election?
- How well timed is the government’s decision to call an election?
- If retail sales are falling, what other element(s) of aggregate demand may support economic growth in the coming months?
- How does UK productivity compare with that in other developed countries? Explain why.
- What possible trading arrangements with the EU could the UK have in a post-Brexit deal? Discuss their likelihood and their impact on economic growth?
The latest figures from the ONS show that UK inflation rose to 2.3% for the 12 months to February 2017 – up from 1.9% for the 12 months to January. The rate is the highest since September 2013 and has steadily increased since late 2015.
The main price index used to measure inflation is now CPIH, as opposed to CPI. CPIH is the consumer prices index (CPI) adjusted for housing costs and is thus a more realsitic measure of the cost pressures facing households. As the ONS states:
CPIH extends the consumer prices index (CPI) to include a measure of the costs associated with owning, maintaining and living in one’s own home, known as owner occupiers’ housing costs (OOH), along with Council Tax. Both of these are significant expenses for many households and are not included in the CPI.
But why has inflation risen so significantly? There are a number of reasons.
The first is a rise in transport costs (contributing 0.15 percentage points to the overall inflation rate increase of 0.4 percentage points). Fuel prices rose especially rapidly, reflecting both the rise in the dollar price of oil and the depreciation of the pound. In February 2016 the oil price was $32.18; in February 2017 it was $54.87 – a rise of 70.5%. In February 2016 the exchange rate was £1 = $1.43; in February 2017 it was £1 = $1.25 – a depreciation of 12.6%.
The second biggest contributor to the rise in inflation was recreation and culture (contributing 0.08 percentage points). A wide range of items in this sector, including both goods and services, rose in price. ‘Notably, the price of personal computers (including laptops and tablets) increased by 2.3% between January 2017 and February 2017.’ Again, a large contributing factor has been the fall in the value of the pound. Apple, for example, raised its UK app store prices by a quarter in January, having raised prices for iPhones, iPads and Mac computers significantly last autumn. Microsoft has raised its prices by more than 20% this year for software services such as Office and Azure. Dell, HP and Tesla have also significantly raised their prices.
The third biggest was food and non-alcoholic beverages (contributing 0.06 percentage points). ‘Food prices, overall, rose by 0.8% between January 2017 and February 2017, compared with a smaller rise of 0.1% a year earlier.’ Part of the reason has been the fall in the pound, but part has been poor harvests in southern Europe putting up euro prices. This is the first time that overall food prices have risen for more than two-and-a-half years.
It is expected that inflation will continue to rise over the coming months as the effect of the weaker pound and higher raw material and food prices filter though. The current set of pressures could see inflation peaking at around 3%. If there is a futher fall in the pound or further international price increases, inflation could be pushed higher still – well above the Bank of England’s 2% target. (Click here for a PowerPoint of the chart.)
The higher inflation means that firms are facing a squeeze on their profits from two directions.
First, wage rises have been slowing and are now on a level with consumer price rises. It is likely that wage rises will soon drop below price rises, meaning that real wages will fall, putting downward pressure on spending and squeezing firms’ revenue.
Second, input prices are rising faster than consumer prices. In the 12 months to February 2017, input prices (materials and fuels) rose by 19.1%, putting a squeeze on producers. Producer prices (‘factory gate prices’), by contrast, rose by 3.7%. Even though input prices are only part of the costs of production, the much smaller rise of 3.7% reflects the fact that producer’s margins have been squeezed. Retailers too are facing upward pressure on costs from this 3.7% rise in the prices of products they buy from producers.
One of the worries about the squeeze on real wages and the squeeze on profits is that this could dampen investment and slow both actual and potential growth.
So will the Bank of England respond by raising interest rates? The answer is probably no – at least not for a few months. The reason is that the higher inflation is not the result of excess demand and the economy ‘overheating’. In other words, the higher inflation is not from demand-pull pressures. Instead, it is from higher costs, which are in themselves likely to dampen demand and contribute to a slowdown. Raising interest rates would cause the economy to slow further.
UK inflation shoots above two percent, adding to Bank of England conundrum Reuters, William Schomberg, David Milliken and Richard Hunter (21/3/17)
Bank target exceeded as inflation rate rises to 2.3% ITV News, Chris Choi (21/3/17)
Steep rise in inflation Channel 4 News, Siobhan Kennedy (21/3/17)
U.K. Inflation Gains More Than Forecast, Breaching BOE Goal Bloomberg, Dan Hanson and Fergal O’Brien (21/3/17)
Inflation leaps in February raising prospect of interest rate rise The Telegraph, Julia Bradshaw (21/3/17)
Brexit latest: Inflation jumps to 2.3 per cent in February Independent, Ben Chu (21/3/17)
UK inflation rate leaps to 2.3% BBC News (21/3/17)
UK inflation: does it matter for your income, debts and savings? Financial Times, Chris Giles (21/3/17)
Rising food and fuel prices hoist UK inflation rate to 2.3% The Guardian, Katie Allen (21/3/17)
Reality Check: What’s this new measure of inflation? BBC News (21/3/17)
UK consumer price inflation: Feb 2017 ONS Statistical Bulletin (21/3/17)
UK producer price inflation: Feb 2017 ONS Statistical Bulletin (21/3/17)
Inflation and price indices ONS datasets
Consumer Price Inflation time series dataset ONS datasets
Producer Price Index time series dataset ONS datasets
European Brent Spot Price US Energy Information Administration
Statistical Interactive Database – interest & exchange rates data Bank of England
- If pries rise by 10% and then stay at the higher level, what will happen to inflation (a) over the next 12 months; (b) in 13 months’ time?
- Distinguish between demand-pull and cost-push inflation. Why are they associated with different effects on output?
- If producers face rising costs, what determines their ability to pass them on to retailers?
- Why is the rate of real-wage increase falling, and why may it beome negative over the coming months?
- What categories of people are likely to lose the most from inflation?
- What is the Bank of England’s remit in terms of setting interest rates?
- What is likely to affect the sterling exchange rate over the coming months?