Unusual Territory

Last week the UK saw an unexpected election result. This week, we had a quarterly Inflation Report out from the Bank of England which covered some unexpected ground, prompting a modest effort by Governor Carney to cover over its tracks.

The Bank surprised everyone by wading into the country’s debate on immigration. This is a pressing political issue at present, and not one which has figured in its previous reports on monetary policy. What is clear from reading the Report itself – and is blindingly obvious logic in any case – is that the high level of net inward migration into unskilled and medium-skilled employment in recent years has depressed wage growth when this is considered as an average across the workforce as a whole. During the course of a lengthy dissertation on supply side economics and the output gap it was inevitable that this would come up.

Mr Carney subsequently gave an interview to a broadcaster known for its libertarian views on border control in which he sought to play down this aspect of the report, but the following summary from the Guardian newspaper compares fairly with the contents of the Bank’s document:

[T]he MPC is deeply divided about how much slack there is in the labour market … a key sentence in the inflation report warned: “It is possible that there is more slack than in the central view. That would be consistent with weaker wage growth recently. And the potential for net inward migration could mimic the effects of slack in terms of its impact on wage pressures.”

In other words, more rapid migration may have been holding down wages.

There is little more to be said on this topic but is interesting to note a significant omission from the Bank’s discussions: the 1% cap on public sector pay introduced in 2012 and pay freeze which preceded it.

When the late coalition took office, wage growth in the private sector had been running at an annual rate of under 1% for some time (and was negative for most of 2009). On the other hand, existing mechanisms had seen public sector wages continue to rise at rates of 3.5-4%. Given the need to reduce a whopping fiscal deficit at the time this pay cap seemed fair. But now the situation has almost reversed. Private sector wage growth is running at about 2.5%: not exactly a bonanza, but princely compared to the 0.5% for the public sector.

This gap is material since public sector workers constitute over 17% of the workforce, meaning that it would account for about a third of the 1% of earnings sluggishness attributed by the Bank to labour market effects. It never gets much attention, however, because the focus is on the headline rate of earnings growth across the economy.

It would nice to think that this is why it was omitted by the Bank. As a frequent consumer of its fascinating reports, however, this blog suspects the real reason is that micro policy decisions like this do not – and to be fair, cannot – appear in the learned macroeconomic works of theory on which the PhDs who compile those reports are whetted.

What there is rather more of in the Report is anecdotal musing on the omnipotence of the central banker of today. We read in the very first section, entitled “Monetary policy and financial markets”, that the ECB is behind the rally in eurozone bonds and the strong performance of Continental equity markets (pp. 9-11). Then on p. 12 we see that the Nikkei has strengthened due to the enhanced intervention of the Bank of Japan. Indeed, amid the discourse on labour supply in Section 3 we learn that: “One factor that will affect how quickly demand responds to higher labour supply will be the response of the monetary policy maker.”

This is in line with market reality: so much trust is being placed in central banks that risk assets are very vulnerable to adverse changes in their rhetoric – never mind what might happen once monetary tightening actually becomes a reality.

To our own Bank’s credit, the Inflation Report and Mr Carney’s own guidance is reasonable. Inflation is expected to pick up again as the base effects of cheap crude fade away, rates will go up, and they probably won’t have to do so sharply though one can of course never be sure. Perhaps it is because we now accept this reality as a given – indeed as an irrelevance – that all the attention has been on what was said about job-seekers from overseas. But while markets may accept with their minds that interest rates will go up, they have not felt it happen for many years (the Bank of England last hiked in 2007). We must hope when the time comes that they will like reality as much as they have found solace in rhetoric.