• Forward guidance: The Bank of England (BoE) has said it will not raise interest rates at least until unemployment falls to a 7.0% threshold and as long as inflation is well behaved. The BoE sees a roughly 50-50 chance that unemployment is still above 7% in late 2016.
  • We expect unemployment to reach 7.0% in Q3 2015: This is a faster decline than the BoE expects, so the first rate rise is probably coming sooner than Mark Carney has argued. Still, we think the threshold will not be met for a long time. Why?
  • The UK is a long way from “normal”: Output is still 3% lower than it was in 2007 and there are 732,000 more part-time workers who want but cannot get a full-time job. So recovering demand growth will result in a jobs-lite recovery rather than rapidly falling unemployment.
  • The labour force is rising fast, because workers are retiring later. This means private sector employment has to grow rapidly just to keep the unemployment rate from rising.
  • The UK is not in a “new normal” of very weak productivity: Higher demand growth pushed up output per employee as well as employment growth in the aborted recovery of 2010. We see no good reason why UK productivity will not rise as demand returns.
  • This is how the economy is behaving right now: Productivity rose 0.4% qoq in Q2. If this continued it would probably be enough to keep unemployment above 7.0% until Q3 2015. Surveys signal that it will continue, with demand rising much more than hiring.
  • The precise forecasts are sensitive: The problem with the threshold is that the point at which it is reached is on a knife-edge. Small changes in the assumptions can lead to big changes in the date the threshold is met. Slightly stronger growth than we expect could get us to the threshold before 2015, but equally slightly weaker growth would delay reaching the threshold significantly.
  • Risks skewed towards hitting the threshold later than mid-2015: We think the balance of risks is clearer though. The two key factors are that the number of older workers could rise faster than we have assumed and so could productivity. The number of older workers has risen rapidly and consistently for 10 years, but we have assumed the pace of increase slows a little. Stronger output growth than we expect would probably show up partly in stronger productivity. The surveys currently point to improving productivity growth.
  • But low chance of the BoE’s late-2016 scenario happening: While we think the risks are skewed, we do not think they are skewed enough to give a 50-50 chance of not reaching the threshold by late 2016. Growth is likely to significantly beat the BoE’s forecasts in the second half of this year and the business surveys have not been a perfect guide to productivity in the past few years. We see a 15% chance of the BoE scenario happening.
  • Problems with the BoE scenario: The BoE growth forecast is cautious. If, over the next 18 months, the UK grows consistently, productivity rises, and real wage growth returns, as the BoE expects, continued negative real interest rates will probably drive accelerating growth in 2016 and bring unemployment down quicker. The best chance of the BoE meeting its scenario is continued stagnation in the economy as the headwinds turn out to be stronger than they and we think.

Rob Wood
Chief UK Economist
+44 20 3207 7822

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