Bank of England’s Interest Rate Calculations Weigh Productivity Against Unemployment

Friday’s gross domestic product figures, showing a 0.8% rise on the quarter, confirmed, instead of a triple-dip predicted by some earlier this year, Britain has has three consecutive quarters of pretty good growth.

This is still not the longest sequence in what has been a stop-start recovery. In 2009 and 2010 there were four successive growth quarters before the snow-affected GDP dip in late 2010. In 2011 growth resumed for three quarters in a row.

The expectation this time among policymakers is that this upturn will prove more durable. That explains George Osborne’s bullishness and Ed Ball’s decision to switch his attack on the government to living standards.

Members of the Bank of England’s monetary policy committee (MPC) are also notably more optimistic. They have moved from a position in which their growth forecasts were upbeat but they were not, to a more consistent recovery message.

Charlie Bean, the Bank’s deputy governor, last week contrasted its upbeat summer 2010 forecasts, based on “a steady improvement in credit conditions amd a gradual decline in uncertainty” with the much more subdued outturn. The uncertainty, particularly over the eurozone, increased rather than declined and credit conditions did not improve.

Now, both those headwinds have eased. Credit is coming through, even for businesses; September saw a rise in net lending to non-financial businesses according to the British Bankers’ Association. Fear of imminent eurzone collapse, with all the chaos that would bring, is greatly reduced, even if the single currency’s underlying problems have yet to be resolved.

So Bean is surely right to argue that this looks like a sustained recovery, unlike previous post-crisis episodes. I also agree with him that we should not expect it to continue at the searing pace suggested by some surveys over the summer.

Growth has surprised on the upside but that does not mean it is a 3%-plus expansion all the way from now on. The latest CBI manufacturing survey pointed to some easing in the pace of growth.

But growth it is, and with it comes the big question, or rather two related questions. Will it resolve the puzzle of exceptionally weak productivity? To remind you, output per worker was fractionally lower in the second quarter than in 2010: normally you would expect it to rise about 2% a year. Output per hour worked was even weaker, down more than 1%.

Related to this is the question of how growth will impact on unemployment. If productivity remains weak, stronger growth will be immediately converted into a faster rise in employment, and a sharper fall in unemployment.

If, on the other hand, productivity picks up as growth strengthens, all the extra workers taken on by the private sector over the past 2-3 years will have to earn their corn. Productivity will rise, reducing the need to take on more staff.
Employment will grow, but not particularly rapidly, and unemployment will take time to fall from its current 2.49m level, 7.7% rate.

This matters in its own right. We need an economy that combines a decent productivity growth with rising employment and falling unemployment. A rise in employment alongside weak productivity is neither healthy nor sustainable.

It matters also because of the Bank’s new approach to monetary policy under Mark Carney’s forward guidance regime. Everybody will know that 7% is the unemployment rate at which the MPC will start to think about raising interest rates.

The Bank is currently revisiting its forecasts ahead of its November inflation report. But the clear message from its last forecast, in August, was that everybody can relax about interest rates. Even after three years, the unemployment rate will not be down to 7% (the MPC’s “best guess” was 7.3%) and, subject to the so-called inflation and financial stability “knockouts” not being breached, rates will stay low. Built into that story was the expectation that as growth recovers, so will productivity.

Some disagree fundamentally. Fathom Consulting, which precedes each inflation report with its own monetary policy forum of ex-MPC members, thinks policymakers are whistling in the dark in waiting for a productivity upturn. Waiting for the productivity bounce is like waiting for Godot.

Its economists believe that Britain suffered a huge supply shock in 2008 from which it has yet to recover. That supply shock has inflicted permanent damage on the economy’s ability to generate productivity growth, with important short-term and long-term consequences.

The biggest short-term consequence is that stronger growth will be converted rapidly into falling unemployment. Far from waiting until 2016 or beyond to get down to a 7% unemployment rate, Fathom thinks it will happen next year.

There is support for its view in the most recent numbers for the unemployment claimant count, a narrower jobless measure. It fell 41,700 in September, its biggest monthly fall since the 1990s, after a drop of 41,600 in August. The unemployment rate on this measure has dropped from 4.7% to 4% in a year. If it is a harbinger of the wider measure, that could indeed race down towards 7% very quickly.

So what will it be? Growth, as noted earlier, may not persist at its very strong summer pace. Productivity, surely, must come back a bit. One prominent theory at the Bank about weak productivity is that it is due to the lack of credit supply to new, rapid growth start-up businesses. Another related argument is that we will see a strong upturn in business investment from now on, which will also help generate stronger productivity growth.

The other get-out is that 7% unemployment is, the Bank insists, a “threshold” not a trigger. Even if unemployment fell rapidly to 7% the MPC would not be impelled to hike rates, merely think about it.

It would, however, also have to issue a new form of forward guidance at that point. A policy that has already generated a lot of controversy would have to be redrafted, if Fathom are right, at an embarrassingly early stage. The Bank has to hope for a productivity revival.

This piece is cross-posted from with permission.