Labor markets and rates normalization

Following unprecedented policy initiatives, global central bankers are beginning to reap the fruits of their labor.  

The U.S. and U.K. economies are now experiencing such positive employment numbers, it almost sounds too good to be true!  

The focus of the U.S. Federal Reserve, one might argue, appears skewed toward full employment despite its dual policy mandate. The 6.5 percent unemployment threshold established by former Fed chair Ben Bernanke was surpassed early in the second quarter. Joblessness in the U.K. now stands at 6.5 percent, better than the 7 percent mark that Governor of the Bank of England Mark Carney had projected, well before 2016. With U.S. core inflation now approaching 2 percent, is an increase in rate imminent?  

While the Bank of England and the Fed appear firmly on track with their policy targets, the Bank of Japan and the European Central Bank continue to face increasing pressure for additional stimulus to spur their respective economies. The inflation and unemployment achievements represent a major divergence among central banks, with the U.S. and U.K. now shifting focus from easy money policy to the timing and path of the first rate increase since 2009. 

Notwithstanding, the U.K. economy has experienced six consecutive quarters of positive GDP growth. However, with the strengthening of the pound, weak demand in key export markets and muted government spending/budget cuts, further growth remains vulnerable to a pullback. For the U.S., despite a negative 2.9 percent first quarter GDP, growth is expected to rebound from the predominantly weather-related weakness as evidenced by strong durable goods orders, business investments and household spending reported in May and June.  

Although much of the economic data remain quite strong in support of a rate increase, at the heart of BOE and Fed policy is the strength of the labor market. The unemployment rates have admittedly been stellar for both economies; however, it is the conflicting wage data that is most troublesome. In her testimony to the Senate Banking Committee in mid-July, Fed chair Janet Yellen cited wage growth as “muted,” lending support for maintaining record monetary stimulus for a considerable period of time.  

While measures of labor utilization saw notable improvements, Yellen said, the data suggests “significant slack” in labor markets are not fully captured in the improving employment rate. Carney echoed similar sentiments following the Monetary Policy Committee meeting in July, alluding to the raging battle of negative real wages. These conflicting metrics are stifling policy actions as any premature change in rates can derail an already prolonged recovery, leaving it vulnerable to shocks. 

Both the BOE and Fed are clearly balancing the need for sustained economic growth versus the perceived slack in labor markets. In the U.S., the average hourly wages adjusted for inflation decreased or came in flat for the last four months. In the U.K., pay growth slowed to 0.7 percent between March and May, signifying a reduction in inflation adjusted wages, and was the weakest reading since record-keeping began in 2001.  

With all eyes on policymakers, labor appears to be the single most important factor in the normalization of interest rates. Some forecasters are now calling for U.S. and U.K. benchmark rates of 2.5 percent at the end of 2016, while a diverging ECB is left to contend with an uneven path to growth, facing 11.6 percent joblessness, close to the 12 percent peak experienced after the crisis. 

While some market participants and policymakers are quite optimistic on the prospects of a strong recovery, the quarterly inflation report from the BOE mid-August will shed further light on spare capacity, growth and inflation rate expectations. A further improvement in the employment rate for both the U.S. and U.K. economies, while keeping inflation at bay, may continue to see benchmark rates remaining range-bound for a considerable period of time.  


Statistics and Data Source: Bloomberg LP., Bureau of Labour Statistics