Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 24 January 2014

Adapting forward guidance

I have a personal form of forward guidance: that I try and wait a day between writing and publishing blog posts. So yesterday I wrote a post reacting to the previous day’s news that UK unemployment had fallen rapidly to 7.1%. That news led to some speculation that the Monetary Policy Committee (MPC) of the Bank of England might change the number for their unemployment ‘knockout’ (the point at which they might start thinking about raising rates) from 7% to, say, 6.5%. There has been similar speculation about US monetary policy. I wrote that I thought this would be unlikely, but rather than let guidance wither away, they would instead prefer to change the nature of their guidance.

So today, as that post laid waiting on my hard drive, I read that Governor Carney indicated that the Bank has decided not to revise its 7 per cent unemployment threshold. “We’re trying to get across that it’s all about overall conditions in the labour market . . . We wouldn’t want to detract from that focus by unnecessarily focusing on one indicator.” So I’ve lost my opportunity of showing that I can anticipate MPC thinking. Perhaps instead I can write about why they might be thinking this way, and what they might specifically do.

The place to start is with why unemployment has been falling much faster than expected. As Chris Dillow explains, it indicates that UK productivity continues not to grow. The Bank hoped that the return of output growth might be accompanied by a resumption in productivity growth, so that unemployment would come down more slowly. They can hardly be blamed for this. Zero productivity growth for four years during a recession was puzzling, but continuing flat productivity when there is a recovery in output growth is in macroeconomic terms just weird. 

So how might forward guidance change? Here we need to make one point, and then ask one question. The point is that forward guidance is all about providing information to the public about what policy might do if events deviate from forecasts. As a result, those critics of such guidance who use poor forecasting as an argument completely miss the point. It is not what I call forward commitment. This leads us to the question: what is it that makes the MPC relaxed about the unexpectedly rapid fall in unemployment?

The answer is in this chart, which shows year on year growth in private sector earnings (source:ONS).

  

The series can be erratic, in part because of bonuses. Indeed, to quote the Bank’s inflation report (pdf): “... growth was volatile in 2013 H1, rising from 0.1% in Q1 to 2.8% in Q2. That largely reflected some people taking advantage of the reduction in the top rate of UK income tax in April 2013, and deferring bonus payments and earnings they would have received in 2013 Q1.” So we can call this the ‘Osborne hiccup’. However smoothing this out, year on year growth has been gradually moving down towards a little above 1%, and there is no sign so far of any reaction to falling unemployment. (Public sector earnings are not growing at all.)

With earnings growth at 1%, and productivity flat, that means unit labour costs are rising well below the inflation target of 2%. If earnings growth stays at 1%, there is no reason coming from the labour market for raising interest rates. If private sector earnings do start increasing by more than 2%, then the focus will then shift to productivity growth. Only if this fails to match the increase in earnings will a rise in rates become a distinct possibility.

So the natural way to change forward guidance is to incorporate this thinking. The unemployment knockout could be replaced with one that says interest rates increases will not be considered as long as private sector earnings growth is not more than 2% above private sector productivity growth. And now I think I should post this, to avoid another rewrite. 


6 comments:

  1. Shifting from one real target to another real target is just going from bad to worse. We can't target productivity with monetary policy.

    Private sector weekly earnings were soaring relative to market sector productivity in 2012, much more than 2% stronger. The current data has private sector total pay growing 5% stronger than market sector output/hour in four qs to 2012 Q3... and that's only after 2012 output has been revised up!

    Elephant in the room is still NGDP. Or just stick with nominal wages. But either of these are going to be basically incompatible with 2% CPI in the face of productivity shocks.

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  2. Firstly, let's all accept Britmouse's point on NGDP/nomial wages shall we!

    Secondly, I would suggest that if wages/earnings are to be targeted, that median rather than mean or aggregate is used? A 1% yoy increase in earnings is likely to hide significant distributional variation - i.e. it could well be that the wealthiest are seeing income growth of several percent, while low earners are being squeezed (I suspect this is the case but don't have data to hand).

    What is clear is that Mr Carney's forward guidance as originally formulated is no longer of much use - I believe he's making a speech today, look forward to Simon's blog - after an appropriate delay! - on that.

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    Replies
    1. Please, please, please stop trying to "fix" the supply-side with monetary policy.

      Monetary policy needs to provide a credible nominal anchor. Median wages are determined by the shape of the income distribution - that is a "real" variable.

      Delete
  3. Zero productivity growth continuing is no surprise at all.
    'It is the competition stupid'.
    EMs in particular China and India have catched up and are moving considerably faster than the developed world. And like what earlier happened at the bottom of the labourmarket is now increasingly happening at the middle part.
    Of course 'back to normal' will correct something but the main issue is the competition is still much cheaper.

    First European victums were the Latinos Bros. Basically they are now a goner/write off. Now it is the turn of the Western frontrunners. Basically it is outsourcing but in a complicated way. Not only cheap production but also having to compete on an international market with say Chinese cies that have much lower labour costs, or compete as a local supplier to cies that compete on the international market.
    Labourcosts (indirectly a huge part of productivity) are internationally seen way too high in the West compared to the new competition. There simply needs to be a correction.

    The problem is that Western Labourcosts is heavily related to consumption and therefor growth. Worldwide that should be compensated by wagesrise in the East. But that is a) delayed and b) unlikely enough to compensate that (overall lower).

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  4. "They can hardly be blamed for this. Zero productivity growth for four years during a recession was puzzling, but continuing flat productivity when there is a recovery in output growth is in macroeconomic terms just weird"

    The answer might be staring us in the face.

    Hundreds of thousands of people are coming off welfare into work. Their productivity isn't going to be high until they improve their skills.

    The composition of workers at this level is beginning to be noticeable in real life. The chance of being served by a Brit in your Tesco Metro or Starbucks is increasing; the UPS delivery man is more likely to be a Brit.

    I apologise in advance for suggesting a non-complex solution.

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  5. "The composition of workers at this level is beginning to be noticeable in real life. The chance of being served by a Brit in your Tesco Metro or Starbucks is increasing; the UPS delivery man is more likely to be a Brit."

    Not in London. Low wages and high costs are still a deterrent to inter-regional labour mobility.

    But the costs of poor job training and job creation for UK nationals during the Great Moderation is coming back to haunt us with the recovery.

    ReplyDelete

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