Good news on UK plc hides behind the Bank of England’s impossible dilemma

UK wages are rising fast, that’s a reason to celebrate, it’s just that other indicators are pointing to trouble ahead. But there is room for optimism.

Article updated: 14 December 2018 9:00am Author: Michael Baxter

In theory, UK inflation should be set to surge. Interest rates should be increased significantly. And in theory, this will bode ill for the UK economy and indebted households. These days, theory rarely holds up.

And as I peruse the latest data, half of the reports seem to be confirming the theory, half seem pretty good.

The bad bits

Let me get two bad bits of news out of the way first. The latest purchasing managers indices point to the growth rate in the UK economy stalling. The latest composite PMI dropped despite the index covering manufacturing rising. The index covering services fell sharply, however. Together the PMIs suggest that the UK’s economic growth was darn close to zero in November.

The latest housing market survey from the Royal Institution of Chartered Surveyors seems to me to provide a big warning sign. This index has long been a great barometer of the UK economy. Sharp falls in the index, dropping deep into negative territory, are invariably followed by an economic slowdown. Sharp rises in the index into positive territory seem to foretell an economic recovery. And in November, the headline index — which measures the percentage difference in the number of surveyors who had recorded a rise in house prices and the number who recorded a fall — fell to minus 11. That is the lowest reading since September 2012.

The better bits

On the other hand, real wages are rising fast. Average wages rose by 3.9 per cent in October, when inflation was just 2.2 per cent. That is the biggest gap between growth in wages and the inflation rate in two years, and one of the largest month-on-month rises in real wages since the 2008 financial crisis.

One must be consistent about these things. When real wages were falling, which they have been for much of the last decade, I wrote here how bad this was for the UK economy. Now real wages are surging, I really should be eulogising about what good news this is.

The problem

The concern relates to good old economic theory. Unemployment is at just 4.1 per cent. Theory suggests that the conditions are in place to see sharp rises in wages that could kick off inflation and thus warrant much higher interest rates.

The fact wages rose so much in October — albeit the reading was distorted by bonus payments — suggests that things are panning out the way theory would suggest it should.

(As an aside, rising real wages should be giving consumer spending, house prices and the UK economy a big boost, but oddly, evidence to suggest this is happening is either non-existent or at best, questionable.)

Interest rates

This all begs the question, given low unemployment and rapidly rising wages, when will the Bank of England slam on the brakes by increasing interest rates sharply?

Answer: The Bank has a dilemma. With all this Brexit uncertainty, right now I would say the odds of hard Brexit, Theresa May deal, and remaining in the EU after-all, calling the whole thing off, are roughly the same: 33, 33, and 33 per cent.

But the fear of hard Brexit, and sterling related turmoil is spooking the Bank. Weakness in the pound should prompt an interest rate rise, fears over a possible hard Brexit suggests UK plc cannot afford higher rates.

And some good news

But I do have some good news. And maybe in a year or two from now, this will mutate into very good news.

UK labour productivity — or output per hour worked — grew by 1.4 per cent in the second quarter, year on year.

Nowhere near enough attention is paid to productivity — it is surely the most important of all economic indicators.

From an historical point of view there is nothing special about an annual rise of 1.4 per cent in productivity — indeed it is below the pre-2008 average.

But by recent standards, that is a pretty good performance.

This suggests that while wages are rising at a fair canter, as productivity is up too, the inflationary effect should not be that great.

The key lies with whether growth in productivity continues. In fact, UK’s total output per employee is a mere 1.9 per cent higher than in 2007. That simple statement probably sums up what has been wrong with the UK economy these last 12 years better than anything.

The hope lies in the prospect that employers may react to the tight labour market and shortage of relevant skills by investing in ways designed to increase productivity.

Combine this with the so called fourth industrial revolution — for example, the internet of things, AI and robotics process automation. We may be on the cusp of seeing much bigger rises in productivity.

If that proves to be right, the economic and thus investing prospects will be bright indeed.
What happens next with productivity is what really matters.


These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.

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