Let's hear it for the Anglo Saxon model

During the 1990s the phrase "Washington Consensus" was increasingly used in policy circles, particularly in the context of the IMF when applying conditional aid packages. It was another way of saying, particularly to developing economies, that countries should liberalise markets; reduce taxes and trade barriers and put in place a governance structure that promotes openness. The ethos was that open and competitive markets would allow the private sector to operate in a manner that acted as a dynamo for economic growth which would ripple throughout the economy. It would also bring them closer to the orbit of the Anglo Saxon economies. Successive US Presidents from Bill Clinton onwards bought into the idea as did UK prime ministers Tony Blair and Gordon Brown. But it was generally resented by those countries which found themselves on the receiving end of IMF requirements.

Indeed, the words Washington and consensus appear rather hollow these days, particularly when mentioned in the same sentence. The events of the past week have painted a picture to the world of a chaotic White House failing to grasp how to run government, and suggests that consensus is the last thing on the minds of many in Washington. Meanwhile, on this side of the Atlantic, the UK government is failing to get to grips with the niceties of Brexit negotiations in a way that makes many of us fear for the outcome. Whatever else the Anglo Saxon model stood for, it was meant to be pragmatism over ideology. Admittedly, there were those who believed that the insistence on the primacy of free markets was an ideological stance, but on the whole it seemed to be backed up by a body of evidence. Then 2008 happened.

Ironically had the free market proponents been allowed to apply their doctrine to its logical conclusion, banks would have been allowed to collapse and the swamp would have been drained in a way that would almost certainly have proved ruinous. Fortunately, governments stepped in to put a backstop behind the system. Contrary to popular belief, markets did not fail. The mechanism worked exactly as the textbooks said it would: boom follows bust. It's just that it did not produce outcomes that societies found acceptable.

I have long maintained that the apparent governmental chaos in Washington and London stems from the events of nine years ago. Unlike continental Europe, where memories of the post-1945 economic ruin were still part of collective memory (albeit distant), neither the US nor UK have any social memory of economic hardship. The experience of the 1930s was too far beyond the memory of most, and had in any case been wiped away by the post-1945 glow. Perhaps it was this factor which meant that US and UK governments were unable to effectively communicate the severity of the economic situation to their electorates (though full marks to Ben Bernanke at the Fed who recognized the collapse for what it was). As time went on, and governments were unable to generate the recovery which they promised, their message was increasingly not heard by an electorate that felt it was being lied to. As a result we got Brexit and Trump.

The problem that governments on both sides of the Atlantic face is that evidence-based policy making appears to have taken a back seat to ideology. Take the Obamacare debacle. President Obama’s Patient Protection and Affordable Care Act is designed to provide health insurance to the estimated 15% of the population who lack it. Moreover, it is designed ultimately to rein in the surge in healthcare spending. But the right-wing Republicans hate it because it is seen as a “job killer” by imposing too many costs on business and is seen as an unwarranted intrusion into the affairs of businesses and individuals. But far from being a job killer, health sector jobs have increased by 9% since the legislation was introduced.

Moreover, Senate voted not to repeal it last week because politicians know that large parts of the current system work for the electorate. As Vox put it, “No legislative strategy can skirt around the fact that millions now rely on the health care law for coverage, and do not want to lose their benefits.” Nor is it clear what the replacement legislation would look like. There are numerous flaws with the Obamacare legislation which need to be fixed in just the same way as there are flaws in the way that the EU operates. This does not mean that it is sensible to overturn the status quo without an alternative plan. There is no evidence that Brexit is a policy that will increase the UK’s economic welfare. And just as certain elements of the US media were able to distort the terms of the presidential debate, so the same thing happened in the UK ahead of the EU referendum.

What is most worrying about the debate on both sides of the Atlantic is that a short-term political agenda is being pursued which will have longer term economic consequences. Both Trump and Theresa May will one day just be another in a long line of ex-politicians. But the damage to their respective countries may well outlive them. In the case of the US, the policy vacuum will create more space for the likes of China to create a global structure designed to maximise its influence. The UK’s position is even worse for it does not have the economic and political heft of the US. The reputation of both countries as economically successful bastions of freedom and tolerance has taken a beating, and the rest of the world may in future only look to them for lessons in how not to manage affairs.

Automotive for the people

In 1979, Gary Numan had hits with two songs which topped the charts around the world: Are Friends Electric and Cars. Almost forty years later, societies are asking themselves whether electric cars are their new friends as policy makers in France and the UK propose a ban on the sale of petrol and diesel vehicles by 2040 in order to encourage the sale of electric vehicles.

According to the IEA around 17% of global CO₂ emissions derive from road transport – a figure which rises to 19% in non-G20 countries (see p35, here). It is thus understandable why governments want to take action. But there are lots of issues which need addressing before we accept that this is a “good” policy, and I do wonder how much of this policy has been thought through. For one thing, it will take action by more than just the UK and France to have much impact on global CO₂ emissions. When the US and China follow suit the policy will have a lot more resonance – or if it were an EU wide initiative, it would make more sense.

The big issue at the heart of the debate is that electric cars are simply not as green as many proponents would have us believe. Sure, they emit less CO₂ but the electricity to power them has to be generated somewhere and if all we do is build more coal-fired power stations it rather defeats the object. It is unlikely, of course, that the government would permit a return to coal, so how will we generate the additional power? Let us start by trying to understand the scale of the problem. The National Grid recently estimated that raising the number of electric vehicles could increase peak UK electricity demand by 8 gigawatts (GW). That is the equivalent of building three new power stations the size of the much-disputed Hinkley Point nuclear station. Admittedly, this does represent an extreme case, with greater use of off-peak charging likely to mitigate the scale of the problem, but it nonetheless makes the point that putting more electric cars on the road requires building more generating capacity.

Having determined that the UK will require up to an additional 8GW of electricity just to keep our cars on the road, how will we generate it? We could simply build another three Hinkley  Point-type nuclear stations, but given all the concerns regarding their cost – not to mention the perennial problem of how to get rid of the waste – this would be highly controversial. We could add more wind turbines but it would mean raising capacity by 50% and we all know how intermittent wind power can be. Solar is probably a non-starter in the UK. However, tidal may be an option with a barrage across the River Severn – which has the second largest tidal range in the word – potentially capable of generating 8GW at peak flow, which would be operational for 8 hours per day, according to a 1989 study. It would be costly (up to £34bn on one estimate, which is almost double the cost of one Hinkley Point) but potentially feasible.

So let us assume that we can generate the electricity. What about the technology – is it good enough to supersede the internal combustion engine?  Only this week, Tesla handed over its first Model 3 which costs $35,000 and has a range of 220 miles (350 km) – about one-third what a larger diesel-engine vehicle is capable of delivering. A longer range version will do 450km on one set of batteries but it costs a third more and is still more limited than cars can do today. In order to manage a 900 km journey across Europe, the standard model requires two charges which, given current battery technology, is not going to be a quick process. Perhaps we could swap over the battery rig, with fully-charged batteries replacing the old ones. This would mean making a couple of quick stops whilst the batteries are swapped but it is not dissimilar to the current process of refilling our cars at a filling station. So far, so possible (at least not too impossible).

But what happens during the transition process towards our 2040 cut-off point? Relatively few people will want to buy a new petrol or diesel car after 2030 given the lack of resale value, so we will need to see significant advances in electronic car technology by then in order to convince people that the transition will happen. That is just 13 years away. And will there be a scrapping scheme to help individuals make the switch (that will be costly)? Will car companies be able to ramp up production to meet likely demand – the likes of Ford argue that Tesla will struggle to increase production on the scale required?  Indeed it is possible that until many of these questions are answered, many Brits (and French) will act like the Cubans by keeping their old cars on the road for longer than they would otherwise do (assuming that petrol stations are not phased out). And how will the oil companies respond? How will governments fill the revenue gap left by the fall in fuel duty which they currently levy on the motorist?

One standard response to these objections is to cast your mind back to 1994 to a pre-internet age when many of the things we take for granted today seemed like science fiction. But the difference is that the technology evolved, and was not imposed upon us. We can still go down to the High Street rather than rely on Amazon deliveries, but the policy as currently portrayed is a bit like abolishing the practice of letter writing in favour of email. Clearly, there are more questions than answers.

Most people are prepared to do their bit to help save the planet but we need a properly thought out response to the questions raised. Announcing a plan then saying we will work out the details as we go along is not a sensible policy strategy. Let us not forget that in the UK, it was new environment minister Michael Gove who announced the death knell of vehicles fuelled by carbon. This was the same man who was fabulously short on detail as to how Brexit would work. There again, he can always go back to his team of experts to help him out – if he hasn’t had enough of them.

What does it take?

There are certain central banking events which have gone down in history. Sometimes the event was only momentous in hindsight, as with Ben Bernanke’s 2002 speech setting out the guidelines of what would later become the QE doctrine. Occasionally, as with Alan Greenspan’s “irrational exuberance” comments in December 1996, it was obvious at the time that something truly memorable had just happened. Another such event took place five years ago when on this day in 2012, Mario Draghi made his famous speech in which he promised that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

It was! Indeed Draghi deserves a lot of credit for keeping the show on the road against a backdrop which threatened to become utterly chaotic. His first act on taking over as ECB President in November 2011 had been to reverse the ECB’s misguided rate hikes earlier that year. But by summer 2012, the euro zone was experiencing an existential crisis with talk of Grexit high on the agenda. Draghi’s words helped calm a fragile market, and by subsequently stepping into the vacuum created by a lack of government clarity, the ECB did indeed do what was necessary. It pumped huge volumes of liquidity into the system and apart from a brief wobble in summer 2015, the euro zone has steadily moved forward. In the sense that Draghi’s goal was to prevent the euro zone from fragmenting, he very much did what was required. Indeed, today there is very much a sense of optimism surrounding the euro zone economy as sentiment continues to rise.

But the ECB still has its foot to the floor, buying huge quantities of government bonds as part of its QE programme and speculation is increasingly mounting as to when and how it will begin tapering its purchases. Meanwhile, the Federal Reserve has been through a tapering process culminating in a cessation of bond purchases, and has raised interest rates by a total of 100 bps since December 2015. Indeed, the Fed is actively discussing balance sheet reduction, so monetary policy normalisation is clearly underway in the US. Despite this, both the MOVE index of US Treasury market option volatility and the VIX index of equity option volatility have touched all-time lows on data back to 1988 and 1990, respectively (see chart). It may be summer, and trading vols have dwindled, but this does raise a question as to whether markets are too complacent. There again, what do markets have to fear?

Central banks have effectively anaesthetised bond markets in recent years and investors have piled into equities with impunity because (a) they don’t really have anywhere else to go and (b) they know that central banks will signal policy changes well in advance, providing them with enough time to get out. The ECB last week failed to give any hints at a policy change and is now effectively on holiday for the next month, and although there is a prospect that Draghi will try to steer market expectations at the Kansas City Fed’s Jackson Hole Symposium in late-August, the markets today seem to be in a mood to see action rather than words. Similarly, the Fed announced a steady-as-she-goes policy today, meaning that nothing will happen on the monetary policy front until September. The BoE may try to inject some volatility into the market following next week’s MPC meeting but it has limited scope to have a wider impact.

Do central banks now need to show that their bite is indeed as bad as their bark? The reason markets are idling along is an indication that they do not fear tighter policy. They should! Central bankers are aware of the dangers of allowing markets to become too complacent because the knee-jerk response in the event of an unanticipated shock will be all the more dramatic. This may explain why various BoE officials have tried to sound hawkish in a bid to jerk the markets into action. Markets may be able to live with the modest degree of tightening we have seen from the Fed so far. So long as interest rates remain low, a dividend discount model in which equity valuations are determined by the discounted value of future revenue streams, will continue to support current levels. But if the Fed starts to run down its balance sheet and put some upward pressure on global bond yields, the equity world may look different.

Unlike in 2012, words no longer appear to be enough. But my sense is that markets ought to take heed of the hints which central bankers are providing. Whatever some investors may think, central banks are not there simply to act as a backstop for market actions. If,  or when, the monetary policy cycle finally turns there is a risk that people might get hurt.

Right on!

A few weeks ago I came across an excellent post on the Flip Chart Fairy Tales blog which looked at the rise of what the author (known only as “Rick”) called “the libertarian right” elements within the Conservative Party and how they captured the economic high ground. Over the past 35 years they have shifted the centre of political gravity in the UK based on an agenda of “cutting taxes, busting unions and privatising everything down to the street lights.” So successful were they in their endeavour that they spawned an imitator in the form of Tony Blair, who introduced a policy based largely based on low taxes and free markets, thus turning the Labour Party into something akin to a continental European social democratic party which consigned the Conservatives to 13 years of political opposition.

Although the political right may have changed the terms of domestic UK politics, they were still not content and devised a call to arms to fend off the creeping influence of the European Commission which, they feared, was about to introduce “socialism by the back door.” Thus was the Brexit war conceived and the terms of engagement defined. But as “Rick” pointed out, “the important thing to understand about right-wing libertarianism is that it is a very eccentric viewpoint. It looks mainstream because it has a number of well-funded think-tanks pushing its agenda and its adherents are over-represented in politics and the media. The public, though, have never swallowed it. Countless think-tank papers, opinion pieces and editorials, telling us that shrinking the state is just common sense and that re-nationalisation is a loony left pipe-dream, have had remarkably little effect.”

We need only look at the way the electorate bought into Labour’s electoral platform this year in a way which confounded nearly all of the pundits.  Although the Conservatives’ 2017 election manifesto tried to be less aggressively free market than in the past, there is a sense that many people are beginning to realise that low taxes imply a reduction in the role of the state which they are increasingly uncomfortable with. The 2017 Social Attitudes Survey pointed out that support amongst the UK electorate for higher taxes and more spending is at its highest in a decade. But only this week prime minister Theresa May raised the prospect that failure to deal with the UK’s fiscal deficit could prompt draconian Greek-style fiscal contraction. It was a bad enough argument when used by George Osborne in 2010: Today, it just seems out of touch.

Brexit will be the ultimate test of the right-wing libertarian economic model in the UK. In the event of Brexit, the UK will be forced to stand alone politically and economically in a way which it has not done for many centuries. Indeed, that part of British history which sees Britain as the plucky underdog fighting against the odds is largely a myth. In a fascinating book which challenges the conventional history of World War II, the historian David Edgerton writes “Empire gave Britain manpower. But even the British Empire, vast as it was, was not alone, and did not feel itself to be alone. It was supported economically and politically by much of the rest of the world … The idea of a small island nation, standing ‘alone’, was far from being the central image of Britain it was to become after the war.” Go back to the Crimean War and Britain fought alongside allies such as France. The decisive intervention in the Battle of Waterloo came from the Prussian von Blücher. We don’t need to labour the point here, but if there is a consistent pattern which emerges from Britain’s history, it is less that it fought alone but rather that it picked its allies well.

Obviously Brexit is not a war. But having decided to decouple from its European allies, the UK will face a testing period as it negotiates its way through a very complex geo-political environment. Failure to get this right could sound the death knell for the post-Thatcherite political and economic establishment, particularly since we may be on the verge of a swing in the political pendulum. More than ever in the last 35 years, the UK will have to show that an economic model based on free markets, free trade and low (ish) taxes can deliver the full employment and rising living standards that EU membership has somehow failed to do. Because if it does not, Jeremy Corbyn’s acolytes are waiting in the wings to show us how to do it with a policy straight out of the 1970s. For some reason, neither of these alternatives set my pulse racing.

Location, location, relocation

Remember the EU Financial Transactions Tax (FTT)? Back in 2011, European Commission President Barroso presented a plan to make sure that financial institutions would “pay their fair share” following the bailouts which banks received in the wake of the financial crisis. Predictably, it led to an outcry with a small but vocal minority, led by the UK, intent on blocking its introduction. Having originally been intended to come into operation in 2014 it has yet to come into law – and probably now never will. Yet as recently as January, the EU Parliament suggested that a draft text could be ready by mid-2017. We are still waiting.

The irony is, of course, that many EU countries already had a form of FTT in place. Even the UK levies stamp duty on equity transactions, having done so since 1694. But with much of the evidence suggesting it would have an adverse effect on certain types of business, with derivatives transactions likely to be the worst hit, the push back was so great that it has been quietly kicked into the long grass. I have long held the suspicion that this would be the case, though when I made this point in a panel discussion in 2013, I was told I was wrong. Unfortunately, I will likely be proved right for the wrong reasons.

It is Brexit that has changed the nature of the debate. On the assumption that this will mean an end to financial services passporting, it is going to become a lot harder to conduct international financial services from London. With Paris and Frankfurt keen to attract business from the City, the chances of the FTT being introduced have gone below infinitesimally small. Although both the French and German governments continue to publicly support the principle of the FTT, it is hard to see either being very supportive at a time when they are scrabbling for London business. With Frankfurt apparently ahead in the business relocation race, the German government is unlikely to push the FTT high up the priority list. And without their support, the FTT is as good as dead in the water. This, of course, makes life rather more complicated for Britain, some of whose politicians assumed that the UK could continue to operate as a low-tax offshore haven.

Abandoning the FTT will certainly make it easier for firms to relocate to other EU locations. Indeed, some business lines simply might not have been profitable in the face of its introduction which could have resulted in them being cut altogether. Now, however, they may be able to continue operating elsewhere. However, abandoning the FTT alone is not going to be enough to persuade business to relocate. Given the pick of European cities to live, many bankers might opt for Paris. After all, it is sufficiently diverse to match the “charms” of London and is certainly one of Europe’s more beautiful large cities. But France is perceived as a more difficult place to do business than the UK and ranks 29th in the World Bank’s Ease of Doing Business index behind other EU members such as Poland and Portugal.

Anglophone bankers might have a preference for Dublin but Ireland may be reluctant to host some of the riskier parts of banking activity, following the problems which it has had to overcome in recent years. The Irish authorities would welcome asset managers, insurance companies and back office functions but may be more cautious about taking on big balance sheet risk given the relatively small size of the economy. It is thus partly due to the lack of alternatives elsewhere that Frankfurt has emerged as the front runner. Germany’s Ease of Doing Business ranking (17) is higher than Ireland (18) , although lower than the UK (7). Frankfurt is also home to the ECB and a well-defined financial cluster has been established in recent years.

One downside is that Frankfurt is relatively small compared to Paris and London, and is already operating at full capacity following the transfer of euro zone banking supervision to the ECB which has pushed up business and residential property prices. The latter in particular is not insurmountable. Anyone who travels 20 miles into central London on a daily basis will find they can do a longer commute rather faster and more cheaply than they can in south east England. Speaking from my own experience, I can testify that the quality of life is also rather better in the Rhein-Main region. If you like a beer, Germany is a good place to be, though if clubbing is your thing maybe you will find Frankfurt a bit tame.

From an industry perspective, however, the real concern is that the integrated European financial services sector will begin to fragment. London will remain the dominant player for some time to come but as business begins to relocate elsewhere it will be replicated on a smaller scale. It will be very difficult and highly costly to build the full infrastructure which the modern industry needs across a number of different European locations. Whilst Frankfurt will probably gain a lot of London business, my long-standing conviction remains that the centre of gravity will inexorably shift towards Asia. This trend may have happened anyway but will certainly be hastened by Brexit. Some politicians might cheer such an outcome for it will result in the de-risking of European financial services that the FTT was designed to achieve. But the British government may come to regret the dismantling of an industry which plays such a crucial role in the knowledge economy that it claims to support.

Still talking at cross-purposes

Twelve months ago, in the immediate wake of the EU referendum, those of us who continued to point out that the UK had made a major policy mistake were derided as “Remoaners” bent on subverting “the will of the people” and that we should all pull together to make the best Brexit possible. I make no apologies for opposing Brexit and disagreeing with its proponents. The known economic costs are too high relative to the unknown economic benefits (if any) whilst the UK’s negotiating position is hopelessly naïve. But as I have pointed out in the past couple of weeks, there are increasing signs that people are beginning to realise the magnitude of the task involved and the voices arguing for a change of tactics are getting louder.

One of the more thoughtful interventions was from former PM Tony Blair (here) who went so far as to suggest that “European leaders, certainly from my discussions, are willing to consider changes to accommodate Britain, including around freedom of movement.” Blair also pointed out that because the opposition Labour Party’s position on leaving the single market is similar to that of the government’s, those wishing for a Labour government to change the terms of the Brexit debate may be disappointed. Indeed, he argued that the combination of the economic policy programme advocated by Labour, coupled with the fallout from Brexit, would be a disastrous combination leaving Britain “flat on our back and … out for a long count.” The problem is that whilst Blair is perhaps the most successful UK retail politician of the last two decades, his legacy has been tarnished by his association with the Iraq War to the point that people within his own party no longer listen to him.

Blair is not alone in his position. An op-ed piece in The Times on Friday by Philip Collins pointed out that “we can’t leave Brexit to the Tory wreckers” (here if you can get past the paywall). He makes the point that whilst it is tempting to ask those who got us into this mess to get us out, “they don’t know what they are doing. Their view of the EU is too ideologically narrow.” That latter point hits the nail on the head. It harks back to my point on homophilous sorting, in which like-minded people talk only to each other without hearing the arguments of the other side.

During the course of the referendum campaign, the simple message peddled by the Leavers resonated with an electorate which wanted to believe that leaving the EU was easy. As Tim Harford notes in his latest piece “last year’s Brexit campaign was based on a simple piece of wishful thinking: Boris Johnson’s idea that the UK could have its cake and eat it. How, exactly, was never quite clear, but desirability bias gave a foolish idea more credibility than it deserved. Voters hoped that Mr Johnson was right, and so they began to believe him: it is so much easier to believe what we already wish is true.”

But for all the evident difficulties in negotiating Brexit and the fact that the collapse in sterling is already making people poorer, there is not a lot of evidence to suggest that many people who voted for Brexit are ready to change their view. A radio phone-in discussion (here), in which a journalist skewered all of the arguments put forward by a Leave supporter who refused to change his view in spite of all of the evidence, is a classic example of all that was – and is – wrong with the debate. I must confess that I was not sure whether to laugh or cry having heard it.

More sober proponents of Brexit, such as Daniel Hannan, remain as resolute as ever. The fact that Hannan is one of the more rational proponents of Brexit should be taken with a pinch of salt:  He was once described by a cabinet minister as an “arsonist.” In an article published in the Telegraph, Hannan calls Remainers “childish” and argues that “there is no prospect of Article 50 being reversed.” This is where I have difficulties with the likes of Hannan: saying something which is unproven as if it were a fact. Lawyers disagree on whether the government can rescind the Article 50 notice, but I am sure the EU27 would be delighted were it to happen (although it is unlikely). Where Hannan is right is that “staying in the customs union would be the worst of all worlds: it would mean that Brussels continued to dictate our trade policy without our having any input into that policy.” Indeed, I made this point a year ago – but what he fails to point out is that leaving is even more damaging. Hannan further stretches the boundary between fact and fiction by arguing that “the majority of the 48 per cent [of remainers] … now want Brexit to succeed. Publicly undermining our negotiators can have only one effect, namely to encourage Brussels to offer harsher terms.” 

One of the real difficulties in the Brexit process is that two sides in the domestic debate cannot agree on how to proceed. We are thus wasting far too much time debating the issue at home when what is required is the presentation of a coherent set of arguments in Brussels. Unfortunately, what we have been presented with over the past year is neither realistic nor sensible, and many people who voted Remain cannot buy into these plans because they represent ideas which are clearly not in the national economic interest. Brexiteers do not seem to understand the damage which a hard Brexit will cause to the UK economy. What is worse, they do not seem to care.

In their book Democracy for Realists, Christopher Achen and Larry Bartels describe a new phenomenon in US politics whereby voters imagine that one party holds a position which fits their view of the world when it clearly does not. This helps explain why those voting for Brexit listen only to the anti-EU part of the Brexit message without hearing the discussion about costs. It may also explain why people voted for Jeremy Corbyn’s Labour Party, as a protest against the hard Brexit Conservatives but without hearing the anti-EU part of Labour's policy.  If this hypothesis is true – and I suspect it is – we have moved beyond rational debate and into the world of dog-whistle politics (though I guess that is not really news). However, it does not mean we should stop making a rational case as to why Brexit is an act of economic self-harm. One day, someone might just listen.

Mr Phillips is resting

Markets are increasingly concerned that central bankers may be about to take away the punch bowl rather earlier than they had previously anticipated. The Bank of Canada was the latest central bank to tighten policy, raising rates by 25 bps this week for the first time since 2010. There is also increased nervousness regarding the policy intentions of the ECB and BoE. But whilst there are good reasons for taking away some of the emergency easing put in place in the wake of the financial crash of 2008-09, it is proving much harder to justify tightening on the basis of inflation than most had expected.

This is a particular problem for the Fed which has nudged up the funds rate in four steps of 25 bps over the past 18 months, but is reliant on signs of higher inflation to justify ongoing policy normalisation. US core CPI inflation, which was running above the Fed’s 2% target rate last year, slipped back to 1.7% in May and June and is thus at the bottom end of the range in place since 2011. Wage inflation has also picked up, but here too the acceleration has been modest, with hourly earnings running at an annual rate of 2.8% in June which is only 0.5 percentage points higher than the average of the last three years.

For an economy which is running close to what appears to be full employment, this might appear rather surprising. But the headline unemployment rate, currently 4.4%, understates the degree of slack in the US labour market. The so-called U6 rate which adds in “marginally attached” workers – defined as “those who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the past 12 months” – is still at 8.6%. This is slightly higher than the previous cyclical trough in 2007 when it reached 8.0%, and significantly above the low of 6.8% recorded in October 2000. Arguably, therefore, the jobless rate can still fall a little further before wage and price inflation starts to become more of an issue.

The UK shows a similar – indeed, perhaps more extreme – picture with the unemployment rate in the three months to May at its lowest since 1975 whereas the rate of wage inflation, at 1.8%, is a full percentage point below that recorded last November. As in the US, there is a significant amount of spare capacity in the labour market. Currently, 12% of those working in part-time employment are doing so because they cannot find full-time employment. Whilst this is down from a peak of 18.5% in 2013, it is still higher than the 8-9% range recorded before the recession of 2008-09 and points to a certain degree of involuntary underemployment. This in turn suggests that there have been structural changes in the labour market which have impacted on the traditional relationship between headline unemployment and wage inflation.

For many decades, economists have focused on the negative relationship between wage inflation and unemployment first postulated by Bill Phillips in the 1950s. In its simplest form, this suggests that policymakers face a trade-off between unemployment and inflation. In practice, the relationship holds only in the short-term, if at all. What is notable, however, is that in the UK and US there has been a flattening of the curve in recent years, suggesting that any negative relationship between wages and unemployment is even weaker today than in the past. 

This is illustrated for the UK in the chart below, based on an idea presented in Andy Haldane’s recent speech entitled “Work, Wages and Monetary Policy.” The chart shows the trend derived from a linear regression of wage inflation on the unemployment rate over various periods. Two features are evident: Most obviously, the line has moved down reflecting the fact that over time inflation in the UK has fallen. But it is also notable that the slope of the line has become shallower. In other words, UK wage inflation has become less sensitive to changes in the unemployment rate. To illustrate the implications of this, we assess the wage inflation rate consistent with an unemployment rate of 5.5% and how this would change if unemployment fell to 4.5% (current levels).

The results are shown in the table (below). Simply put, an unemployment rate of 5.5% would be associated with wage inflation of 14% on the basis of the relationship over the period 1971-1997, falling to 4.1% between 1998-2012 and just 2.1% on the basis of the data for 2013-2016. But what is also interesting is a one percentage point fall in the jobless rate to 4.5% has a much smaller impact based on recent years’ data than in the pre-recession period. For example, this might have been expected to produce a 0.9 percentage point rise in wage inflation over the 1997-2012 period compared to a 0.5pp rise based on recent data.

Space considerations preclude a look at the reasons for the weaker sensitivity of wage inflation to labour market conditions. It may be the result of factors such as a lower degree of unionisation; the more widespread use of zero hours contracts and the rise of the gig economy, all of which have raised the degree of slack which the headline unemployment rate does not capture. But what the analysis does suggest is that policymakers can afford to spend less time worrying about the impact of low unemployment on wage inflation. There may be a case for higher interest rates but it is not to be found in the labour market.

As a final thought, I am struck by certain parallels with Japan. Following the bursting of the bubble economy, the Japanese authorities failed to spot the structural factors which led the economy to the brink of deflation, notably an ageing demographic profile which prompted a switch towards saving rather than consumption. The one factor we might be missing today is the impact of automation, which threatens a significant substitution of capital for labour and which could put downward pressure on the relative price of labour. I would thus not be in a hurry to raise interest rates to counter a wage inflation threat which has so far failed to materialise.