No need to increase interest rates while real earnings are falling

Any move now to increase interest rates might put the economic recovery at risk.

Bank of England 2-JPEG

Tony Dolphin is chief economist at IPPR

The Office for National Statistics (ONS) has published an extremely strong set of numbers this morning. Employment is increasing at a rapid pace and unemployment has fallen sharply.

Importantly, most of the new jobs that are being created are now full-time ones and as a result the number of people working part-time who want full-time work has fallen, as has the number of people working involuntarily on temporary contracts.

For the next few months at least, the outlook is positive. Surveys show business confidence is high and suggest firms are looking to take on more workers. The overall number of vacancies is increasing.

The UK economy appears to have developed some positive momentum after two years of near stagnation. Employment growth is boosting incomes, which is allowing spending to increase, which in turn is leading to higher output growth and more employment.

With unemployment having fallen to 7.1 per cent, there will be speculation about an increase in interest rates. Mark Carney’s attempt to reassure markets that rates would not be going up for some time by issuing ‘forward guidance’ that unemployment would have to fall to 7 per cent before any move was considered is looking like a bad move  – unless he wants rates to go up in the first half of this year, which is doubtful.

Any move now to increase interest rates might put the economic recovery at risk. Forward guidance, by providing reassurance that interest rates will not rise, has been one of the factors that has given firms the confidence they need to step up hiring. Higher interest rates would risk strangling the recovery while unemployment is still well above its pre-recession level.

In any case, there is no evidence that falling unemployment is creating wage pressures. Today’s figures show average earnings are still increasing at an annual rate of less than 1 per cent. There is no need to increase interest rates while real earnings are falling for most workers.

It is also too early to be sure about the medium-term sustainability of the economic recovery. This is not the export and investment-led recovery that the chancellor promised us; it is built in large part on a renewed rise in household debt. The time to contemplate interest rate increases is when the economy is firing on all cylinders.

2 Responses to “No need to increase interest rates while real earnings are falling”

  1. Foullaini

    Just rejoice at that news.

  2. JobSeeker

    Tony Dolphin fails to explain exactly why interest rates are often raised when an economy is growing. At a time when the unemployed are still being demonised (including by Labour politicians!) Mr Dolphin is being coy about how interest rates are used to ensure there is enough unemployment to exert sufficient downward pressure on wages. A report in the Independent in 1999 entitled “How wage inflation has been tamed” was more forthcoming about why the Bank of England had raised interest rates the previous summer – it said the following:

    “EIGHT MONTHS ago the Bank of England was so concerned about inflationary pressures in the labour market that it hiked UK interest rates up to 7.5 per cent. Unemployment was unsustainably low, the Bank said, and would have to rise in order to keep inflation in check.”

    http://www.independent.co.uk/news/business/how-wage-inflation-has-been-tamed-1071220.html

    A higher interest rate will, by degree, reduce the number of new business start-ups, will force more struggling businesses to the wall, and will reduce the number of businesses choosing to borrow for expansion. Additionally, consumers will also have less money to spend on goods & services if more of their earnings go into paying their mortgage & any other variable-rate loans. These factors combine to reduce the demand for labour and, all other things being equal, will lead to higher level of unemployment and lower real wages than would otherwise exist at a particular point.
    This is what lies behind the practice of inflation targeting, which aims to ensure that profit margins don`t get squeezed by wage rises which would cause businesses to put their prices up.

    Here`s an extract from the Bank of England`s August Inflation Report (see page 28 under the heading “The equilibrium unemployment rate is affected by a range of factors that change over time”) where it says:

    “The longer that people are out of work, the more their skills will deteriorate and as a result, the probability of them finding a job decreases — those who have been unemployed for over a year are, on average, around a third as likely to find work as the short-term unemployed. That is likely to mean that they will exert less downward pressure on wages and so the equilibrium unemployment rate in the medium term will remain elevated.”

    http://www.bankofengland.co.uk/publications/Documents/inflationreport/2013/ir13aug.pdf

    The “equilibrium unemployment rate” is the rate of unemployment necessary to control inflation in the bank`s estimation, it is more often known as the “Non-Accelerating Inflation Rate of Unemployment” or NAIRU for short. The unsanitised truth about unemployment can be read here:

    http://thetruthaboutunemployment.wordpress.com/2012/09/17/what-causes-unemployment-2/

Leave a Reply