A Sterling threat to the UK recovery

The UK’s unemployment rate is now at its lowest level since 2009, giving the Bank of England scope to consider raising interest rates next year. But the strengthening currency is cause for concern.

The unemployment rate in the United Kingdom fell to its lowest level in four-and-a-half years in the three months to October. This provides further evidence that the UK recovery is on track and gathering steam, although the Bank of England is concerned that an appreciating pound may put growth at risk.

The UK’s unemployment rate fell to 7.4 per cent in October, from 7.6 per cent in the three months to September. It places the unemployment rate tantalisingly close to the Bank’s threshold of 7 per cent, after which it has said it will consider raising the cash rate.

Obviously there is still a long way to go for the UK economy. Much like the improving US labour market, I would not characterise conditions as strong, but they have improved significantly. There is still a high level of long-term unemployed, while average hourly wages are rising at a subdued pace – two problems equally present in the US.

The strength in employment growth has completely surprised the Bank of England, which in August thought it was likely that the unemployment rate would hit 7.4 per cent in 2015. Despite revising up their outlook for the economy in their November Inflation Report, those forecasts now appear to be somewhat pessimistic.

It is certainly creating some problems for the Bank’s forward guidance doctrine, which has had an unimpressive beginning. Indeed, forward guidance has resulted in increased volatility in bond rates, with maturities of two years or more and caused widespread market confusion. I doubt the unemployment data will help in that regard.

That said, if forward guidance is going to prove unreliable, it’s preferable for it to be too pessimistic. Indeed, it would be a welcome change, given the period following the global financial crisis was characterised by central banks across the world providing overly optimistic forecasts that missed the mark by some margin. I think Bank of England Governor Mark Carney might cope better with the upside surprise.

Carney reiterated yesterday that the Bank would not act prematurely – or automatically – when that threshold is reached. However, many economists are now predicting that it will raise rates, perhaps as soon as late next year.

I expect the Bank to once again adjust its communication, perhaps putting greater emphasis on the fact that the threshold is not a trigger or alternatively lowering the threshold a little bit. Don’t expect an immediate move if the unemployment rate hits 7 per cent.

Not surprisingly, the pound appreciated in response to the news, and is now near a five-year high against a number of other currencies. The Bank will be concerned that a high pound may pose additional risks to achieving balanced growth and that the economy needs to rely more on business investment and exports rather that consumption, which drove growth in the September quarter.

In light of this it seems reasonable to suggest that the Bank will want to continue with its asset purchases – even with the improving outlook – which has been putting some downward pressure on the pound. The Fed’s decision to begin tapering earlier today – and expectations that they will continue to do so – might also help to lower the pound a little in 2014.

Inflation has eased in the UK in recent months and this will allow the Bank to maintain the current level of stimulus, even if the labour market pushes through the 7 per cent unemployment rate threshold.

It is clear that economic conditions have improved in the UK over 2013 but it is important that markets don’t get ahead of themselves. There are still a number of underlying concerns for the UK, including productivity growth, wages and a fragile eurozone recovery. These factors all have the potential to derail the economic recovery, if given the opportunity.

Despite the recent strength in the UK, I expect the Bank will maintain exceptionally loose monetary policy until the unemployment rate pushes towards 6.5 per cent (rather than the current threshold of 7.0 per cent). With inflation remaining contained, there is little pressure on the Bank to make a move in 2014.

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