The UK's recovery enters a critical phase

Strong job growth in the UK is a key indicator of economic strength but there are a number of headwinds that could get in the way of a sustained recovery.

The labour market in the UK continues to improve but wage growth remains subdued and inflation is at its lowest level since 2000. Recent developments have certainly shifted back expectations for a rate hike but, with oil and food prices so volatile, don’t be surprised if interest rate expectations shift wildly over the course of the year.

The unemployment rate fell to 5.8 per cent in the three months to November, down from 6 per cent in the three months to August, and is now at its lowest level since August 2008. Strong job growth has seen the unemployment rate fall by 1.3 percentage points over the past year.

Particularly important -- and unlike the US -- the fall in the unemployment rate has coincided with a sharp rise in the participation rate. This has effectively put upward pressure on the unemployment rate and makes the recovery all the more impressive.

Measures of economic activity suggest that the UK economy continued to grow at an above trend pace towards the end of last year. In the minutes to its January board meeting, the Bank of England notes that bank staff expect growth of 0.8 per cent in the December quarter and 0.7 per cent in the first quarter of 2015.

That’d be considered below trend growth for a country such as Australia -- that has enjoyed an unprecedented run of prosperity -- but for the UK, persistent growth of that magnitude would point to a recovery that has found its footing and managed to prosper despite the ongoing debacle in the eurozone.

But it isn’t entirely smooth sailing for the UK. It still faces the twin headwinds of poor productivity and wage growth, while there are also ongoing concerns that the recovery has only benefited a narrow segment of society. These factors are important indicators of living standards and, unless they improve, the UK recovery will prove short-lived.

Average weekly earnings increased by 1.7 per cent over the year to the latest three-month period. Clearly the pace of growth has picked up considerably but wage growth itself remains quite subdued and well below the levels that were considered normal pre-crisis.

Private sector wages are 2.1 per cent higher over the year, while public sector wages have climbed just 0.8 per cent and, until recently, were growing much slower than consumer prices.

Inflation has recently eased -- driven by lower oil prices -- which should help support household wages and spending in the coming months (Don’t be too concerned about deflation in the UK, January 14). A lower oil price effectively acts as a tax cut for households and businesses and increases their purchasing power.

As spare capacity continues to ease, it is reasonable to expect mounting wage pressure, particularly within the private sector, but the Bank of England warns that those gains might be delayed.

According to the bank, “around 40 per cent of pay settlements would be agreed in April when, according to Bank staff’s latest estimates, 12-month CPI inflation was likely to be around zero, so there was a risk that any pickup in pay growth might be delayed.”

That suggests that inflation will remain subdued, not only during the first half of this year, but into the second half as well. It’s no surprise that the market has also scaled back its assessment of both the pace and timing of policy normalisation.

The labour market and economic growth point to an economy that could justify higher interest rates. But soft inflation suggests that there is no urgency for the Bank of England to act right now.

The key indicators to look out for in the months to come will be oil prices and wage growth. A pick-up in the latter and a stabilising of the former would quickly shift inflation towards the top of the Bank of England’s annual target and prompt movement on the rates front. That suggests that the outlook for interest rates in the UK could be quite volatile this year, depending on international markets that the central bank has little influence over. 

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