Labour Market: The Brightest Spot In The Recovery

BMI View: The UK labour market has defied the odds over the last few years by adding over a million new jobs in the face of weak economic growth and cuts to the public sector workforce. Moreover, employment data have become more important as a gauge for the health of the economy and the trajectory of monetary policy. Whether or not the recovery in employment is matched with a resurgence in productivity will determine whether the current economic recovery is sustainable and if monetary policy can be normalised.

The UK labour market has been the most noticeable bright spot in an otherwise lethargic economy over the last few years, with over a million new jobs being created. The latest data further fuels the positive sentiment building around the broader economic recovery. Total job gains increased by a whopping 250,000 in the three months October, the second largest reading on record. In addition, the unemployment rate has edged down to 7.4% in October from 7.6% the previous month.

What really stands out is that the unemployment rate has gone down even when the total labour force has continued to increase. In other developed states labour forces have shrunk on the back of falling participation rates, which might lower the unemployment rate when it should be stable, or leave the unemployment rate stable when it should be rising. In other words, headline unemployment figures can be misleading if changes in the labour force are overlooked. In the case of the UK, the fall in the unemployment reflects a genuine improvement in the labour demand.

Remarkably Strong Job Creation
UK - Change In Employment (3m/3m)

Labour Market: The Brightest Spot In The Recovery

BMI View: The UK labour market has defied the odds over the last few years by adding over a million new jobs in the face of weak economic growth and cuts to the public sector workforce. Moreover, employment data have become more important as a gauge for the health of the economy and the trajectory of monetary policy. Whether or not the recovery in employment is matched with a resurgence in productivity will determine whether the current economic recovery is sustainable and if monetary policy can be normalised.

The UK labour market has been the most noticeable bright spot in an otherwise lethargic economy over the last few years, with over a million new jobs being created. The latest data further fuels the positive sentiment building around the broader economic recovery. Total job gains increased by a whopping 250,000 in the three months October, the second largest reading on record. In addition, the unemployment rate has edged down to 7.4% in October from 7.6% the previous month.

Remarkably Strong Job Creation
UK - Change In Employment (3m/3m)

What really stands out is that the unemployment rate has gone down even when the total labour force has continued to increase. In other developed states labour forces have shrunk on the back of falling participation rates, which might lower the unemployment rate when it should be stable, or leave the unemployment rate stable when it should be rising. In other words, headline unemployment figures can be misleading if changes in the labour force are overlooked. In the case of the UK, the fall in the unemployment reflects a genuine improvement in the labour demand.

Unemployment Falls Even As Labour Force Increases
UK - Labour Market Data, mn

The UK has also managed to create jobs in the face of weak economic growth and cuts to the public sector workforce. Even before the recovery suddenly burst into life in 2013, the UK was adding jobs throughout 2010-2012 when the economy had effectively flatlined. We believe that this owes in part to labour hoarding as employers have sought to lock in skilled labour for fear of suffering shortages when the economic recovery finally takes hold. We have also argued that it partly reflects an improvement in labour market flexibility. Countering the cost of employing full-time staff, some firms have increased their workforce by adopting more flexible labour contracts and taking on more part-time workers.

Participation Rate Still Climbing
UK - Labour Force Participation Rate, %

The rebalancing from public sector to private sector job creation has also been a key development, and one with a strong political element. While Chancellor of the Exchequer George Osborne has failed to meet his own self-imposed timetable for fiscal deficit reduction, his claim that the private sector would create enough employment to soak up public sector job losses has proven reasonably prescient. This further plays into Osborne's strategy of making fiscal reform the issue that defines the parliamentary election in 2015. His opposite number, Labour's Ed Balls, has already been forced to go along with fiscal austerity in the next parliament (a failure to do so leaves him vulnerable to criticisms of being fiscally irresponsible) and drop his accusations that unemployment would surge further on the back of austerity. Labour has recently shifted its approach to highlighting the fall in real wages, which has been referred to as a 'cost of living crisis'. If real wages start to increase next year, then Labour's new line of attack will come under pressure.

Real Wages Still Under Pressure
UK - Real Wage Index

The Productivity Puzzle

The sceptics argue that rising employment in the face of a stagnant economy points towards a secular downshift in productivity that will hamper the UK's potential growth rate. Since the financial crisis we have not been convinced by this argument. Although capacity in some frothy industries has been lost, the ability of the UK to lure in foreign investment and skilled labour suggests that the slowdown in productivity could be more cyclical than structural, albeit still weaker compared to the pre-crisis period. The UK has long been one of the biggest recipients of FDI as a result of an attractive business environment that has long been welcoming of foreign investors. Efforts by the government to introduce a more competitive and simpler tax system, and to reduce burdensome red tape, will further increase the appeal of the UK's business environment. The fact that UK labour has become a lot cheaper to the rest of the world as a result of the fall in real wages and the depreciation of the pound, has also not been lost on foreign firms.

UK Labour Now A Lot Cheaper
UK - Weekly Wages

Foreign investors not only bring funds to start or expand production capacity (whether in the industrial or service sectors), but also technology and knowledge transfer which in the long run will boost the experience and skills of UK workers. We are not even perturbed about foreign money flowing into the property market (although frothy prices are a concern for economic stability). The dismal performance of the UK construction industry has been key in holding back the recovery. Signs that the confidence in the construction sector is taking off is positive for the economy and for the employment of skilled workers. Over the long term, the pent up demand for property (UK house building is extremely low) and infrastructure (particularly transport and energy) will offer opportunities for foreign investors and for job creation.

Nearing A Productivity Surge?
UK - Productivity Index

We also view positively the increase in employment (despite flatlining productivity) from the perspective of skills generation and preservation. In an economy where unemployment is going up, skills can be lost either through obsolescence (for the long-term jobless) or from workers leaving the labour force. Replacing lost skills is difficult and can damage long-term potential growth. In the case of the UK where employment has been increasing, the acquisition of experience and skills from being in work are positive for longer-term productivity growth. We would also finally add that more people in work means more people with incomes to spend in the economy and fewer people claiming out of work benefits that would otherwise inflate the fiscal deficit.

Employment Data Has Become More Significant

The issue of productivity will be a defining one for both the economic recovery and monetary policy. If we are correct in assuming that the productivity slowdown is cyclical and not structural, then a burst of productivity growth could be due in a few years down the line, which will solidify the integrity of the recovery. For Bank of England Governor Mark Carney, who has conditioned monetary policy on developments in the labour market, productivity will be an important consideration as to whether the central bank will raise interest rates. The introduction of an unemployment target (used as a proxy for excess capacity in the economy) has changed the way markets price in the trajectory of monetary policy, with monthly jobless data taking on a new level of significance.

How Close Is The BoE To Raising Rates?
UK - Employment Data & Projections (mn), Unemployment Rate(%), RHS

Our chart above shows a rather crude exercise in which we assume a continuation in the labour force and employment growth trends over the last 12 months. Under this scenario, unemployment would fall below the 7.0% threshold by mid-2016. We would stress, however, that even if unemployment falls below 7.0%, the BoE may not tighten right away, particularly if there are signs that productivity has still not recovered.

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