News In Charts: Wither UK Forward Guidance?

This research note is provided by Fathom Consulting. All of the charts below and many many more, covering a range of topics and countries on both the macroeconomy and financial markets are available in the Chartbook to Datastream users at www.datastream.com. Alternatively you can access Fathom’s Chartbook at www.fathom-consulting.com/TR.

The latest set of UK Labour Market Statistics painted a picture of a rapidly tightening labour market, as unemployment moved to within a whisker of the MPC’s 7.0% threshold. Forward guidance, introduced last August, is defined in terms of the headline rate. In the January release, this covered the three months from September to November, and stood at just 7.1%. As we set out below, close inspection of the single-month figures suggests that headline unemployment probably fell below 7.0% in the final three months of last year. As recently as November, the MPC saw less than a 5% chance that this would happen. What next for forward guidance? We doubt that the Committee would vote simply to lower the threshold and carry on as before. It may choose an alternative intermediate target, such as wage inflation. But the most likely outcome, in our view, is that members will put their flagship policy of forward guidance quietly to one side, and return to taking each month as it comes. Inflation targeting of old, in other words. Of one thing we can be certain. The Committee appears untroubled by the prospect of higher inflation – wrongly in our view. And it is in no hurry to raise Bank Rate.

Employment gains in the early part of the jobs recovery were driven primarily by part-time workers and self-employment but, as our chart illustrates, employment growth is now being driven by full-time employees. Meanwhile, the numbers of hours worked continued to outpace our estimate of GDP growth. Not only is productivity failing to recover in line with the MPC’s projections, it is still falling.

Refresh Chart Edit Chart

The Labour Force Survey, used to construct headline measures of employment, unemployment and inactivity, is a survey of households. Each household in the survey is interviewed once every three months, meaning that a third of all participants are surveyed each month. In turn, each monthly sample is comprised of five overlapping cohorts. Each time the sample is interviewed, one cohort leaves and a new cohort enters. Natural variation across the population means that some cohorts will tend to exhibit a higher rate of unemployment than other cohorts. By examining the three-month change in the single-month unemployment rate, we can get some idea of the direction in which each cohort is moving.

Refresh Chart Edit Chart

The single month unemployment rate for November was 7.4%, 0.6 percentage points lower than the corresponding figure for August. The single-month unemployment rate for October was 7.0%, 0.7 percentage points lower than the corresponding figure for July. If we assume that the declines seen over these two three-month periods are representative of the underlying trend in unemployment, it would point to a single-month figure of 6.5% in December. That in turn would put the headline rate at 6.9%. Consequently, we see a better-than-evens chance that, when next month’s Labour Market Statistics release is published on 19th February, it will be evident that the headline unemployment rate breached the MPC’s threshold during the final quarter of last year.

In the latest set of Minutes, published at the same time as the labour market data, the MPC acknowledged that it would soon have to make a further substantial revision to the point at which it expects the headline unemployment rate to reach 7.0%. Back in August, when the policy of forward guidance was introduced, 7.0% unemployment was seen as a very distant prospect. Indeed, it was not expected to happen until beyond the forecast horizon – that meant 2016 Q4 at the earliest. As recently as the November Inflation Report, the MPC saw less than a 5% chance that unemployment would have reached the 7.0% threshold by the end of last year.

When it publishes the February Inflation Report, the MPC is likely to acknowledge that, to all intents and purposes, we are already at 7.0% unemployment. What then? We doubt that the Committee will vote to lower the unemployment threshold. There was no discussion of such a move in the January Minutes. Moreover, Governor Carney is reported to have said, when interviewed at Davos, that in future he would be ‘against unnecessarily focusing on one indicator’. It seems, then, that the policy of forward guidance based purely on a threshold for the unemployment rate will soon come to an end. What will replace it? The Committee might choose to monitor a number of alternative indicators, including wage inflation, alongside or instead of the unemployment rate. But monitoring a range of alternative indicators is good-old fashioned inflation targeting in all but name. We think it most likely that members will vote to bring the experiment to an end, and return to a world where policy is set month-by-month.

Of one thing we can be certain. A raft of speeches given by policy makers over the past few weeks suggests that the Committee is largely untroubled by the prospect of higher inflation. We are far less sanguine. We set out our own UK view in this column last August. The supply potential of the UK economy has been severely damaged, both by the crisis itself, and by the response of policy makers to that crisis. The output gap has more or less closed, and productivity will remain subdued as demand continues to grow rapidly. That means output will move ahead of potential, and inflation will start to rise during the second quarter of this year, moving above the 2% target and close to letter-writing territory.

We suspect the Committee will keep Bank Rate on hold at least until there is firm evidence that inflation is moving materially above target. And on past experience, even a prolonged period of inflation that is not only above target, but in letter-writing territory, may not be sufficient to trigger a response. Knowing that a tightening of policy risks triggering a significant correction in the UK housing market, and recognising that this in turn would kill off the recovery, the temptation to look through a further period where inflation is not only above target but rising may prove compelling. According to the minutes, the Committee saw no immediate need to raise rates once the threshold had been breached, and that when the time did come to do so, it would be done ‘only gradually’. Of that we can be sure.

Refresh Chart Edit Chart

We see upside risks to sterling in the near-term, especially against the euro, as markets continue to price in a tighter monetary policy stemming from strong growth and a rapidly tightening labour market. Sterling has already risen by around 10% on an effective basis since March, taking it to levels not seen since late 2008. It probably has a little further to go yet.

Refresh Chart Edit Chart

However, looking further ahead, sterling looks vulnerable to us. If we are right about inflation, markets will expect a response from the MPC, and in all likelihood the MPC will be slow to deliver. The current account deficit is currently as large as it was on the eve of the UK’s ERM exit. With this in mind, it leaves the pound looking vulnerable to a substantial fall further ahead. Indeed, many of the necessary ingredients for a good old-fashioned sterling crisis appear to be in place.

Receive stories like this to your inbox as they are published. Subscribe here and follow us @Alpha_Now on Twitter. If you are looking to access our data or analytics, register for a free trial.