22 June 2022
There are some tentative signs that demand for labour started to ease in August. But the labour market is still red hot, thanks in no small part to soaring levels of sickness, which hit a record high in August. This is pushing up pay growth, and makes it more likely that the Monetary Policy Committee will opt for a jumbo rate hike of 1% in November.
The key unknown for monetary policy is how many of these inactive people will be tempted back into the workforce due to the cost-of living-crisis. This will make a big difference for how quickly the unemployment rate rises, how fast wage growth comes down and how high interest rates will have to rise.
Sickness at record levels
There were almost nine million people inactive in the UK in the three months to August, a whopping increase of 250,000 from the three months to May, and 500,000 more than before the pandemic. Most of this increase in inactivity is because of the number of people who are long-term sick.
This is a headache for the government and the Bank of England. First, the government has no chance of meeting its 2.5% GDP growth target without getting more people back into work. Labour shortages are still a major factor in preventing the economy from rebounding.
Second, the labour market is tightening not because more people are in work, but because there are fewer people in the workforce. Indeed, the rise in inactivity caused a drop in the unemployment rate to 3.5%, its lowest level since February 1974. This is despite the number of people in employment falling by 109,000 in the three months to August.
The tight labour market means growth in regular pay (excluding bonuses) was 5.4% among employees in the three months to August 2022. This is the strongest growth in regular pay seen outside of the pandemic period. Average regular pay growth was a massive 6.2% for the private sector – that is miles above the 3% to 3.5% that’s consistent with the 2% inflation target. Although, given soaring inflation, in real terms over the year regular pay fell by 2.9%, a near-record drop.
Normally, we would expect a cost-of-living crisis to tempt more people back into the workforce as they try to maintain their standard of living. However, that doesn’t seem to be the case this time. The labour market tends to lag the real economy, so it could be that more people will seek work over the winter. But as most of the increase in inactivity is in long-term sick, it suggests it is people’s ability to work, not their willingness, which is the issue. That implies a permanently smaller workforce.
Admittedly, there were signs that demand for labour is easing. Vacancies fell by 46,000 on the quarter to hit 1.246m. This is the largest fall on the quarter since June to August 2020. What’s more, survey indicators point to a slowdown in hiring. The RSMUK MMBI has been telling us for a few months now that firms are reassessing their hiring needs.
We expect vacancies to continue falling sharply over the next year as firms reduce their demand for labour. The coming recession will also raise unemployment levels, but given the surge in the number of people on long-term sick leave significantly reducing the workforce, we expect the unemployment rate to rise to only between 4.5% to 5%, a historically low figure, especially during a recession.
The policy takeaway
The economic outlook has drastically changed since the MPC delivered a second straight hike of 50 basis points (bps) in early September. The enormous, unfunded, fiscal giveaway announced by the government on 23 September prompted a massive shift in expectations for interest rates and a depreciation of the pound – which the MPC will need to respond to. Expect a hike of 100bps in November.
Markets see an 80% chance of a 125bps move, but we think the real risk is of the MPC underwhelming us. Specifically, if the government delivers a credible fiscal plan on 31 October that shows how it will pay for tax cuts and get debt under control, then it’s possible the MPC will feel comfortable opting for a smaller rate increase.
The impact of the higher rates on the economy and the housing market will also be a key consideration for the MPC. It has said it thinks rates at 5% would create stress in the mortgage market.
The bottom line is that the Bank of England is in sensitive territory as it attempts to balance the need to shore up confidence in UK assets against both the adverse impact higher rates have on the economy and the risk of a credit crunch. That risk is a very good reason to think the MPC’s actions will ultimately be underwhelming relative to market expectations. As a result, expect rates to peak at 4.75% early next year.