UK pay growth is picking up strongly, consistent with the historical relationship with the job openings or vacancy rate*, a measure of labour market tightness. This relationship suggests a continued upswing through mid-2016, at least.
The three-month smoothing of average weekly regular earnings (i.e. excluding bonuses) rose by 2.7% in the year to April, the largest annual increase since February 2009. Total earnings and earnings per hour also grew by an annual 2.7%. Hourly earnings had been lagging the weekly measure (i.e. employees’ average weekly hours had been rising) but the gap closed in April – see first chart.
A post in September argued that weekly regular earnings growth, then below 1%, was about to rise significantly, since the job openings rate had surged over the prior two years and had almost regained its pre-recession peak, indicating a tight labour market – see second chart, which is reproduced from the earlier post. The Bank of England and consensus view, by contrast, was that hidden slack (e.g. a large number of part-time employees wishing to work full-time) and rapid labour supply expansion would limit upward pressure on pay.
The weakness of earnings growth in 2013-14 seemed to support the consensus view that the job openings rate was overstating labour market tightness. The two series had turned down simultaneously in 2008 so their divergence in 2013-14 suggested a structural break in the relationship.
As noted in the earlier post, however, the openings rate led earnings growth by between six and 12 quarters at turning points in the 1970s and 1980s – third chart. The simultaneous fall in 2008, therefore, was unusual but the divergence between weak earnings growth and a surging openings rate in 2013-14 was not.
The current earnings pick-up is consistent with the historical relationship. As noted in the earlier post, “the openings rate bottomed in 2009 but embarked on a sustained rise only in the second quarter of 2012. Based on the average nine-quarter lag following the three increases over 1970-90, this suggests an upswing in earnings growth starting in the third quarter of 2014.” Regular earnings growth has risen steadily from a low of 0.7% in the second quarter of 2014 – fourth chart**.
The increase in pay growth is more impressive against a backdrop of falling / low consumer price inflation, which would be expected to subdue wage demands.
The job openings rate rose further in the fourth and first quarters, surpassing its 2008 peak, though has since fallen slightly. If the first quarter were confirmed to be a peak, the minimum six-quarter lead in the 1970s-80s would suggest a continued uptrend in earnings growth through the third quarter of 2016, at least.
*Vacancies as a percentage of employee jobs plus vacancies.
**Quarterly data except for the last data points, which refer to the latest three months.
The balance of US activity news has improved so far in June, supporting the widely-held view that the economy is rebounding from weather- and strike-related weakness in early 2015. Monetary trends suggest that the pick-up will extend into late 2015 but investors should be wary of extrapolating optimism into 2016, for several reasons.
First, monetary strength may be fading. Six-month growth of real narrow money peaked in February, though appears to have remained solid in May* – see first chart. Real narrow money leads activity (industrial output) by nine months on average**, so this suggests that economic growth will moderate at end-2015.
Secondly, corporate finances are deteriorating. The “financing gap” of non-financial corporations, i.e. capital spending minus retained earnings, rose to 1.2% of GDP in the first quarter, the highest since the second quarter of 2008 – second chart. The gap is not yet at a worrying level but increases historically have preceded economic slowdowns or recessions, albeit sometimes with a long lead – third chart.
Note that the financing gap does not include borrowing to fund share buy-backs and M&A. A wider deficit measure including net equity buying tends to lead the yield spread between non-investment-grade corporate bonds and Treasuries and reached 4.3% of GDP in the first quarter, suggesting future spread widening – fourth chart.
Thirdly, cycle analysis warns of a possible economic downturn in 2016-17. This was discussed in detail in a post last August but, to summarise, the Kitchin stockbuilding cycle is scheduled to reach a low between 2015 and 2017, and the Juglar business investment cycle between 2016 and 2020. There is a risk that the downswings in the two cycles will coincide in 2016-17, producing a recession.
A recession should be signalled well in advance by a sharp slowdown or, more likely, a contraction in real narrow money – as previously discussed, such a contraction occurred before 10 out the 11 post-WW2 recessions, the exception being the 1954 downturn, which had a large fiscal element***. No such signal has yet been given.
*Based on May monetary data and a forecast of the consumer price index.
**Based on a study of G7 data over the last 50 years. The study – available on request – also confirms that real narrow money is superior as a leading indicator to real broad money, real bank lending and the rate of change of real bank lending (i.e. the “credit impulse”).
***Real government spending fell by 6.4% between 1953 and 1954.
US job openings (vacancies) surged in April, consistent with the forecast here of economic reacceleration from the spring, following a rebound in real narrow money growth in late 2014 / early 2015 – see previous post.
The job openings rate (i.e. vacancies expressed as a percentage of the total number of jobs) rose to 3.7% in April, the highest since 2001. The official openings series begins at end-2000 but earlier numbers can be estimated from help-wanted data compiled by former Fed economist Regis Barnichon. The current openings rate is close to the 2000 cycle peak of 4.0% – see first chart.
The job openings rate is inversely correlated with the unemployment rate, leading the latter at turning points by an average of four months since 1970. The level of openings forecasts the flow rate of unemployed people into employment. A rise in this flow could, in theory, be offset by an increase in layoffs. Weekly initial unemployment claims, however, remain low, as does the monthly layoff tally compiled by Challenger, Gray and Christmas.
Based on the average four-month lead, the further rise in job openings suggests that the unemployment rate will continue to fall until August, at least. Mr Barnichon’s model, indeed, predicts that the jobless rate will smash through 5.0% over the summer, reaching 4.5% by end-2015.
The job openings rate is positively correlated with pay growth, as measured by the annual change in the wages and salaries component of the employment cost index (ECI), with a six-month average lead at turning points since 1983, when the ECI series begins. The recent pick-up in pay growth, therefore, may extend into late 2015, at least – second chart.
A recovery in the Fed’s preferred inflation measure – the annual change in the personal consumption chain price index excluding food and energy – from its April level of 1.2% is probably also required, but labour market trends are consistent with a September interest rate rise.
Domestically-generated inflation has risen and is above 2%
Domestic inflation is key because it determines where CPI inflation will settle when the effects of commodity price weakness and sterling strength dissipate.
A national accounts-based measure of domestic inflation is the annual increase in the deflator for gross value added (GVA), which measures the prices of goods and services produced in the UK. This rose to 2.2% in the first quarter of 2015.
The GVA deflator, moreover, has been suppressed by the fall in price of North Sea oil production. The GVA deflator excluding oil and gas rose by 2.7% in the year to the first quarter – the largest annual gain since 2009.
As well as signalling a likely strong rebound in CPI inflation, the rise in domestic inflation casts doubt on the MPC’s judgement that there is still slack in the economy (of about ½% of GDP, according to the May Inflation Report). Inflation should trend lower while slack persists, according to conventional doctrine.
The GVA deflator can be viewed, from the income side, as the sum of two components – employee compensation per unit of output and “other income” per unit of output. The large annual rise in the GVA deflator excluding oil and gas is accounted for by strength in the latter component – see first chart. Above-trend economic growth, in other words, has been reflected in upward pressure on corporate profit margins and self-employment incomes.
The danger is that the employee compensation component now takes up the running as wages pick up in response to a tight labour market. The annual change in unit compensation rose to 1.7% last quarter, the highest since 2013.
Economic growth is likely to remain above trend
The rise in domestic inflation would be of less concern if the apparent economic slowdown in early 2015 were to be sustained. Monetary trends, however, suggest that GDP growth will remain at around its 2013-14 level, which was associated with steady elimination of economic slack.
The second chart compares rates of change of GDP excluding oil and gas and measures of inflation-adjusted broad money (M4), narrow money (M1) and corporate money (M4 holdings of private non-financial corporations). The real money measures have given advance warning of economic fluctuations in recent years and their current growth rates are similar to or higher than in 2013-14.
Bank interest rates have fallen, delivering an effective monetary loosening
The MPC cut Bank rate to a minimum in 2009 partly to counteract a sharp rise in the spread between commercial bank deposit / lending rates and Bank rate in the wake of the financial crisis. The spread, however, has narrowed since 2012 as funding conditions for banks have eased, resulting in a 0.5 percentage point fall in the average bank interest rate vis-à-vis households – third chart.
Monetary policy was sufficiently loose in 2012 to produce solid economic growth in 2013-14. By keeping Bank rate stable as bank interest rates have fallen, the MPC has allowed an unwarranted further easing of domestic monetary conditions.
A possible counter-argument is that the impact of lower bank interest rates on monetary conditions has been offset by exchange rate strength, with the sterling effective rate rising by 8% since end-2012. The risk, however, is that this strength unravels rapidly. Historically, UK monetary policy-makers have frequently delayed necessary tightening because of concern about a temporarily high exchange rate, with inflation and interest rates subsequently rising significantly.
Global monetary trends have been suggesting faster economic growth in the second half of 2015 – see previous post. May business surveys are consistent with this scenario: a weighted average of G7 manufacturing purchasing managers’ new orders indices rose significantly, with improvements in six of the seven countries (Germany being the exception) – see first chart.
The coming growth pick-up is at least partially discounted in markets, judging from recent divergent performance of global equities and government bonds, and relative strength of cyclical stocks. The key issues now are how long the upswing will last and whether it will give way to another slowdown in 2016.
Six-month growth of global real narrow money reached a peak in February – second chart. The lead time from real money to output has averaged eight months at the last three growth turning points, suggesting that economic momentum will top out around October.
Real money growth remained solid in April, consistent with little economic slowdown in late 2015. It is likely, however, to fall further as inflation continues to recover, assuming that commodity prices are stable at current levels – third chart.
A plausible scenario, therefore, is that strong second-half growth will give way to a loss of economic momentum in early 2016, following a real money slowdown this summer. The coming upswing, in other words, will prove to be another false down.
How could this be too pessimistic? One possibility is that nominal money growth will strengthen, offsetting the inflation drag on real money expansion. The most likely source of a rise in global money growth is China, where trends are showing signs of improvement and recent policy easing has yet to feed through – see previous post.
An alternative growth-bullish possibility is that money velocity will pick up, or at least fall at a slower rate. A rise in velocity has the same economic impact as an increase in real money. A measure of the velocity of G7 narrow money is far below its declining long-term trend, suggesting the potential for a rebound – fourth chart.
What could trigger such a turnaround? The surprising answer is a rise in US interest rates. Velocity has increased when the Fed has tightened historically – fifth chart. Correlation is not causation, but this suggests that Fed tightening initially results in a stronger economy as the velocity effect outweighs the (lagged) impact of higher rates. An early Fed move, perversely, may warrant greater near-term economic optimism.