Speech given by Mark Carney, Governor of the Bank of England at the 146th Annual Trades Union Congress, Liverpool 9 September 2014
President and Congress.
It is a pleasure to be in Liverpool today to discuss the prospects for the UK labour market.
The growth and distribution of jobs and incomes matter to everyone.
Employment does much more than provide the means to support workers and their families; it is essential to personal fulfilment and human dignity.
Part of that dignity is being paid a living wage.
Over the past year, the Bank of England has ensured that its pays all of its 3,600 staff at least the living wage.
And we have recently brought all our contracted service staff in central London up to the London living wage.
We are in the process of our final review. But I can announce today the Bank’s intention to become anaccredited Living Wage employer by the time of the next TUC conference.
Of course, the Bank of England’s responsibilities for promoting the good of the people of the United Kingdom go much further than being a responsible employer.
We manage monetary policy to achieve price stability: low, stable and predictable inflation.
And we promote financial stability by regulating and supervising financial institutions as well as by taking targeted actions to insure against unsustainable indebtedness, as we did earlier this year for the housing market.
By maintaining price and financial stability we put in place the foundations for sustainable job creation and income growth.
Stability gives workers the confidence to invest in skills or to change jobs. And it gives firms the confidence to hire new workers, invest in new equipment, introduce new products and pursue new markets. We need workers with the right skills. And we need companies taking strategic initiatives to grow productivity. That productivity is needed to secure real wage increases over the medium term.
And as I will explain, the labour market is central to our decisions – decisions which must take into account both short-term fluctuations and the profound changes sweeping labour markets across advanced economies.
These changes include:
Collectively, these trends have affected the dynamism of labour markets and the spending patterns of families.
And they have interacted with the forces unleashed by the Great Recession to challenge the durability of the expansion.
The Great Recession led to enormous dislocations in advanced economy labour markets.
In many economies unemployment and underemployment skyrocketed. Youth unemployment reached perilous levels.
Central banks responded with unprecedented monetary stimulus.
That was consistent with their price stability mandates. And it recognised the threat that the recession might permanently scar the workforce.
As the recovery in many advanced economies has evolved, central banks are assessing the extent of structural changes in labour markets and are grappling with what they mean for monetary policy.
The answer is not uniform across major economies. This is one reason why monetary policy in the US, euro area and the UK can be expected to be less synchronised than in recent years.
1. A tale of three labour markets
Indeed, despite common underlying influences, differences in how the labour markets of major economies responded to the Great Recession have been striking (Refer to attachment below: Chart 1).
Take the world’s largest economy – the United States – as a benchmark.
Unemployment there more than doubled during the recession. While that rate has recently fallen back, that headline is much better than the details.
The number of Americans in work has only just returned to where it was before Lehman failed, even though there are now 14 million more people of working age.
Much of the fall in the unemployment rate is the result of workers in their prime leaving the labour force. (refer to footnotes from the attachment below)
Far more vacancies remain unfilled than usual, indicating big mismatches in the labour market. And fewer people than normal are switching jobs, suggesting an ongoing reluctance to take risks.
The American labour market still is not working as it once did.
Even though times for many families have been tough, relative to that benchmark, the UK labour market has performed well.
Despite a recession that was deeper and more prolonged, unemployment did not rise as much and has fallen back sharply since. (refer to footnotes from the attachment below)
In contrast to the US, this rapid fall has been accompanied by significantly higher participation rates.
There are now over one million more people in work in the UK than at the start of the crisis. Total hours worked are some 4% above their pre-crisis level.
That exceptional employment performance has come at a cost, however: wage growth has been very weak. Adjusted for inflation, wages have fallen by around a tenth since the onset of the crisis.
To find such a fall in the past, you would have to look back to the early 1920s.
The weakness of pay has, in effect, purchased more job creation. It has not resulted in an unusually high level of profits.
The burden of the Great Recession has been shared across the UK. Profits have been squeezed almost as much as labour costs. Employees have seen their real incomes reduced, but more people are in work as a result.
In the US, the burden has been much more concentrated on those who have lost, and not regained, work. And in contrast to the UK, American companies have increased their profits significantly as a share of national income.
The euro area
What makes the UK performance even more remarkable is that we have faced the added challenge of rebuilding competitiveness.
In the run-up to the crisis, the UK’s economy had become increasingly imbalanced.
When the crisis hit, sterling fell by a quarter. Prices of imported goods rose sharply and that fed through to higher inflation.
The squeeze on real incomes was pronounced. And yet there were relatively few calls for higher wages to compensate.
As a result of that painful adjustment, the UK is more competitive. And if the world economy returns to a surer footing, there is a real prospect that the UK can properly rebalance its economy. (refer to footnotes from the attachment below)
Euro-area countries have needed to make similar – if larger – adjustments to restore competitiveness but with less flexible labour markets and without a flexible currency (Refer to attachment below: Charts 2-4).
The results have been dire. Euro-area unemployment has risen sharply over two successive recessions to its current rate of over 11%. It stands at over 14% in Portugal, 20% in Spain, and 25% in Greece.
Over 6% of the euro-area labour force is now long-term unemployed and in danger of becoming detached from the labour market (refer to footnotes from the attachment below). And despite high unemployment, there is evidence of labour shortages.(refer to footnotes from the attachment below)
There is a clear danger of a misplaced if not lost generation of workers in the euro area and in the US. Britain’s labour force and trade unions deserve great credit for ensuring that this risk is much lower in the UK. By sharing the burden, our economy is better positioned for the future. The question is whether we will seize the opportunity.
2. Why the UK labour market outperformed: a labour supply shock
Before considering how we can, it is helpful to understand just why the UK labour market has outperformed.
When the recession hit, the demand for labour naturally fell. But surprisingly the potential supply of labour appears to have increased as well with an estimated 1.5 million people entering the labour force.
The number of additional people wanting to work overwhelmed the longer-term effects of population ageing, which, all else equal, would have been expected to have removed around half a million people from the labour force (Refer to attachment below: Chart 10).
This expansion of the workforce is being driven mainly by women and older workers. Before the Great Recession, between 46% and 83% of those in the 50- to 64-year-old age cohort were active. Now it is between 60% and 89% (Refer to attachment below: Table 1). In part this reflects a continuation of past trends within age cohorts, but it goes much further. (refer to footnotes from the attachment below)
The greater risks and financial burdens that many are now facing are likely to be important drivers of the recent increase in the labour force.
Changes to pension arrangements have encouraged people to work longer (refer to footnotes from the attachment below). State pension ages are rising, and the default retirement age has been abolished (refer to footnotes from the attachment below).
Reforms to the UK’s welfare system, including attaching job-search conditions to welfare payments, could have prompted those affected to seek work. (refer to footnotes from the attachment below)
Sharp falls in wealth and increased uncertainty about future incomes following the financial crisis have undoubtedly changed many people’s retirement plans, making them work longer and retire later in order to
compensate. (refer to footnotes from the attachment below)
And the scale of the debt accumulated by Britain’s households in the run-up to the recession has encouraged more people to work, and to work longer (refer to footnotes from the attachment below). Around 40% of households reported being concerned about their levels of debt in 2013 (refer to footnotes from the attachment below). Almost a tenth of households in a recent Bank of England survey said they were working more because of concerns about repaying their debt.
So the strong performance of the UK labour market reflects in part people feeling compelled to work for financial or other reasons.
When British workers have been challenged, they have not given up (Refer to attachment below: Charts 5-8). Some have taken less productive or lower-skilled jobs. Others are working part-time. Some have become self-employed. Others are prepared to do the same work for less than they would have done.
Wage pressures are, on past relationships, as low as if the unemployment rate were around 10%, not the 6.4% it is today ((refer to footnotes from the attachment below: Chart 9).
With more workers at competitive wages, companies have been encouraged to hire. They already had reason to favour labour over new capital investment given the higher cost and lower availability of credit following the financial crisis (refer to footnotes from the attachment below).
This substitution of labour for capital across the economy has continued to lower productivity per hour worked.
That weak productivity growth is not the result of laziness on anyone’s part. It is a natural consequence of so many people wanting to work and companies employing them in place of capital.
Since the typical economist asks whether what they have observed can work in theory, the annex shows how a ‘labour supply shock’ results in a lower path for real wages and productivity, higher employment, and greater downward pressure on wage growth at any particular rate of unemployment.
Although the adjustment has been painful, trading off lower productivity and wages for much higher employment, on balance it provides a solid foundation for a durable expansion. That is because keeping people in work through a recession maximises the prospects for individuals and the economy.
By staying in work, individuals retain and learn new skills. And they are better placed to participate in the expansion when it gathers force. This can make a material difference to an individual’s lifetime earnings (refer to footnotes from the attachment below).
For the economy, maintaining workforce attachment is the best way to ensure that cyclical downturns in aggregate demand for goods and services do not translate into permanent reductions in our economy’s potential to supply them.
As a result, Britain has an opportunity, not often seen after a deep recession, to reach and sustain a higher level of employment than in the past. And workers can maximise their pay prospects.
But, you rightly ask, when will this start? When will Britain get a pay rise?
The expansion of labour supply does not mean permanently weak growth of real incomes.
As employment approaches its new higher level, wage pressures should increase and capital investment should continue to recover. Productivity growth should pick up bringing the higher, sustainable pay rises that British workers deserve.18
Specifically, the Bank’s latest forecast expects real wage growth to resume around the middle of next year and then to accelerate as the unemployment rate continues to fall to around 5½% over the next three years.
By the end of our forecast, we see 4% nominal pay growth on average across the economy. This is consistent with our inflation target and the economy’s potential. I will touch at the end of my remarks on how workers and employers can raise that potential.
But first let me turn to the implications of all these labour market developments for monetary policy.
3. Monetary policy implications
One of our roles at the Bank of England is to deliver price stability in a way that supports jobs and growth.
Our price stability objective is clear: the inflation target of 2% CPI inflation.
Supporting jobs means helping the economy reach the maximum sustainable level of employment. That level changes as the economy changes.
That is why, a little more than a year ago, even though inflation had been above the target for most of the past five years and economic growth was poised to accelerate, we did not raise interest rates from their historic low level of ½%.
We did not because we recognised that the UK had a huge number of unemployed and under-employed workers and that the economy was running below full capacity. We expected inflation to fall back. We saw that confidence might have been returning, but it remained fragile. We knew the nascent recovery was not yet secure.
So we used the flexibility in our remit, given to us by Parliament, to return inflation to the target over a longer period than usual in order to support sustainable jobs and growth.
To make our intentions clear, the Bank committed not to even think about raising interest rates from historic lows at least until unemployment fell back to 7%.
That guidance gave businesses the confidence to hire and invest. It reassured households that the costs of servicing their debts were not about to rise abruptly at a time when they remained particularly sensitive to interest rates. And it evolved with the economy.
The effectiveness of that policy has been reinforced by the healing of the financial sector. Prompted by the Bank of England, British banks have raised over £140 billion in new capital in the past few years. They are right-sizing their balance sheets and re-focussing their businesses.
The recovery has exceeded all expectations. It has momentum. There has been a sustained and sharp fall in the unemployment rate to 6.4%. Over 800,000 jobs have been created in the past year alone. We expect robust growth of 3½% this year and 3% in 2015.
The challenge now is to secure a durable expansion; to make sure the economy realises its full potential.
What does that mean for interest rates?
With many of the conditions for the economy to normalise now met, the point at which interest rates also begin to normalise is getting closer. In recent months the judgement about precisely when to raise Bank Rate has become more balanced.
We have no pre-set course, however; the timing will depend on the data.
Moreover, the precise timing of the first rate rise is less important than our expectation that, when rates do begin to rise, those increases are likely to be gradual and limited. Rates will go up only as far and as fast as is consistent with price stability as part of a durable expansion, with the maximum sustainable level of employment.
For a variety of reasons ranging from the weakness in the euro area, to ongoing repair of household balance sheets, we are not expecting interest rates to head back to the levels seen before the Great Recession (refer to footnotes from the attachment below).
The actual path of interest rates will be determined by the evolution of the balance of aggregate demand and aggregate supply.
Before the crisis, monetary policy largely tracked developments in aggregate demand because the structural dynamics of labour supply and productivity growth were relatively consistent (refer to footnotes from the attachment below). But in the wake of the crisis, the supply side of the economy has been anything but predictable.
Originally, we thought the major uncertainties were centred on productivity growth.
But as the Bank’s Monetary Policy Committee (MPC) has seen wages, employment and productivity evolve, we are increasingly of the view that there has been a material labour supply shock for the reasons that I have discussed.
So we have been paying increasingly close attention to developments in the labour market. Our forecasts for the next three years, and hence our interest rate decisions, are based on key judgements that:
In short, and unlike the US and euro area, the economy is likely to be able to sustain a higher level of employment than in the past. The uncertainty is less the direction of that development and more its magnitude.
To assess that magnitude and its implications for inflation, we are tracking a range of indicators, including those of the prospective paths for wages and unit labour costs.
Actual wage growth, at just 0.6% since a year ago excluding bonuses, is currently very weak. (refer to footnotes from the attachment below) However, there are some leading indicators that point to a modest pick up over coming quarters.
For example, job-to-job flows have been increasing (refer to attachment below: Chart 11) and some surveys of pay growth have picked up more sharply in the last year. Although the relationship between these surveys and average wage growth has become less robust in recent years (refer to attachment below: Chart 12), they do offer encouraging evidence of better wage prospects for those changing or finding new jobs.
Of course, the pay of existing employees needs to pick up as well. After all, what matters for economy-wide inflation is the average wage relative to economy-wide productivity. (refer to footnotes from the attachment below) To that end, we will be closely monitoring pay settlements that are bunched around the turn of the year and taking a steer from the pay of new hires as a potential leading indicator of broader pay pressures.
Some observers have discounted the implications for inflation of the recent weakness of pay growth because it stems from the types of jobs being filled – a ‘compositional effect’. However, these are real jobs being performed by real people, and an increase in lower-skilled lower-wage jobs is one consequence of working-off the labour supply shock. We also need to be mindful of the possibility that it represents part of a longer-term trend towards job polarisation.
What matters for inflationary pressures, irrespective of the type of job, is the relationship between wages and productivity, as captured by unit labour costs. Across the economy, wage growth is barely above productivity growth. Unit labour costs are currently soft (growing at only around 1% in the economy as a whole), are below the growth rate necessary to meet the inflation target, and indicate that there is further to go before we reach the new sustainable level of employment.
In other words, there is still slack in the labour market that must be used up, and the recent revisions to the profile of UK output up to 2012 seem unlikely to change that assessment materially. That slack is wasteful. And if it were to remain, inflation would remain below the 2% target.
The MPC’s current best collective judgement is that, while it has narrowed rapidly, this slack is broadly in the region of 1% of GDP. As this margin of slack continues to narrow, we expect wages to pick up slightly faster than productivity, and unit labour cost growth should increase, consistent with meeting the inflation target.
However, the MPC expects it will take the better part of three years for this to happen.
With inflation at 1.6%, continuing downward pressure from the appreciation of sterling, and with slack remaining, the current inflation environment is benign. But it will not remain benign if we do not increase interest rates prudently as the expansion progresses. Our latest forecasts show that, if interest rates were to follow the path expected by markets – that is, beginning to increase by the spring and thereafter rising very gradually – inflation would settle at around 2% by the end of the forecast and a further 1.2 million jobs would have been created.
In other words, we would achieve our mandate.
There is, as always, uncertainty about the future.
But uncertainty does not mean stasis. You can expect interest rates to begin to increase.
The exact path will depend on the economy. Our assessment will undoubtedly change as the economy evolves and policy will of course be adjusted if geopolitical events have a material impact on the outlook.
If indicators suggest the economy is moving more slowly towards our goals, we will have learned that we are further from sustainable capacity. Prospective wage and unit labour cost growth will be weaker. Rates will go up later and more gradually.
And should we see faster progress, prospective wage and unit labour cost growth will be stronger, which will suggest we are closer to maximum capacity and that the economy can sustain higher rates sooner.
In all events, rate rises can be expected to be gradual and limited compared to the experience of the UK in the past.
We are under no illusions. The Great Recession was a calamity. Britain’s workers have borne many of the consequences.
Our job is to ensure the economy achieves its potential and to maintain price and financial stability, for sustainable growth in jobs and incomes.
But monetary policy cannot do it alone.
Others – including trade unions, government and businesses – will determine the potential of this economy. You will ultimately determine the size of Britain’s pay rise.
Those in work need to be able to seize new job opportunities in a world where technology and globalisation cause labour markets to shift rapidly.
Skill levels need to be raised continually. That is of course first and foremost about education. But crucially it also means access to lifelong learning, both on and off the job, available to all.
The TUC’s engagement with the UK’s skills agenda is a major contribution to realising that imperative. In the past year alone, unionlearn, has supported over 200,000 people to invest in their skills.
Such investments are crucial for the durability of this economic expansion and for Britain’s future. They will help to deliver long-term productivity – so that the British people get the pay rise they deserve.
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