Once upon a time, macro-economics was relatively simple. Unemployment went down and wage rises and inflation went up, summarised neatly by the Phillips Curve, the inverse relationship between inflation and unemployment. This was subsequently modified to allow for a “natural” rate of unemployment – a rate at which inflation is stable – and which similar to the concept of the vertical long run aggregate supply curve introduced by neo-classical economists.
However recently life has become more complex. Imagine an economist who has just been rescued after being marooned on a desert island for two years. Like all good economists their first reaction is not to seek a good meal or even a drink but to head straight to a newspaper or the Office of National Statistics website to see what has happened to the economy. They would be confused.
If they looked at The Times then, in one edition, (Friday 19th Feb) they would find a report from the OECD cutting its growth forecast and urging governments to spend more which conflicts with George Osborne’s plan to cut the budget deficit. They have reduced the UK’s forecast growth by 0.3% to 2.1% and the USA forecast by 0.5% to 2.0%, but both economies are predicted to do better than other advanced economies. However an alternative forecast from last month suggests that UK economic growth will accelerate this year up to 2.6% while the Bank of England’s most recent forecast talked of a cut to 2.2%. Incidentally our shipwrecked economist would have missed the election and would possibly be surprised to find Mr Cameron in No 10 and Mr Osborne next door in No 11.
In the same paper there was also a report quoting a senior Bank of England official who was expecting interest rates to rise sooner than the City predicts and another highlighting the UK’s low level of productivity, indicating that the UK’s productivity has fallen further behind other leading Western economies that at any time in the last 25 years. While our recently-rescued economist might not be surprised by Germany (output per hour 36% higher than the UK) he or she would be amazed by France, Italy and even (31%, 10% and 5% respectively) higher than the UK). The low productivity was most pronounced in manufacturing (25% less productive than Germany and 45% less productive than the USA). A recent report from KPMG identified investment in education and the transport infrastructure as being crucial to remedy the situation. However all is not totally gloomy since the newspaper also contained an article highlighting the record growth in fast-growing businesses (companies with more than 10 staff ) growing at over 20% a year.
Unemployment has fallen consistently and, at 5.1%, the lowest for a decade, is only just above the 5% estimate of the natural rate; it is predicted to drop to 4.7% by 2018, the lowest level since 1975. Job vacancies are at a record high and the percentage of people in work rose to 74.1%, the highest level for 45 years (since records began). However wage growth remains low with the annual rate of pay growth slowing from 2.1% to 1.9%. This could be because low inflation allows employers to offer lower pay rises, or because of an increased pool of labour from rising numbers of older workers, part-time workers, migrants and young people entering the labour market.
However inflation has remained persistently low, only rising from 0.2% in December to 0.3% in January but still way below the Bank of England’s 2% target which they do not expect to reach until early in 2018. Core inflation, which strips out volatile items such as food and energy fell last month from 1.4% to 1.2%. Furthermore pay increases continue to stagnate. The issue for economic policymakers is to try to predict when (or if) wage rates are likely to increase and, if so, when interest rates will need to be increased. Such an increase, when it comes, will need to be contrasted with the possible need for a stimulus if the likely fall in UK economic growth occurs.
(Note how the inflation data provides an ideal example of how one can be mislead by headlines – how different does a rise from 0.2% to 0.3% sound from a 50% increase in the rate of inflation in one month!).