The MPC supposedly places significant weight on an estimate of  the “medium-term equilibrium unemployment rate” in calibrating its policy stance. The August 2013 Inflation Report, for example, stated that “The gap between actual unemployment and the medium-term equilibrium unemployment rate is a measure of effective slack in the labour market, and is likely to be most relevant for assessing wage pressures over the MPC’s three-year forecast period.”

So what is the Committee’s current judgement about this crucial policy metric? The May Inflation Report, on close inspection, is contradictory. The text at the top of page 30 of the Report refers to a current estimate of 6-6.5%. Chart 3.7 on page 28, however, contains a first-quarter figure for the “unemployment gap” – the difference between the actual and medium-term equilibrium rates – of 0.9%. Since the MPC expected actual unemployment to be 6.7% in the first quarter, this implies an equilibrium rate of only 5.8%.

How has this contradiction arisen? One possibility is that Bank of England staff generated the 5.8% estimate but the MPC majority refused to endorse their assessment, preferring a 6-6.5% range. Chart 3.7 may have been retained in the Report owing to an editorial insight, or because the still-significant unemployment gap shown supports the dovish policy stance of Governor Carney.

The single-month unemployment rate fell to 6.45% in April, within the MPC majority’s 6-6.5% range for the medium-term equilibrium rate. The MPC believes that there is additional labour market slack associated with part-timers working fewer hours than they would like, although the implications of this shortfall for wage pressures is uncertain. With a further unemployment decline assured, the majority position suggest an interest rate rise before end-2014.

Governor Carney, of course, is strongly resistant to such a scenario, and may press for a downward revision to the estimated range for the medium-term equilibrium unemployment rate in the August Inflation Report, probably to 5.5-6%. This change would be presented as a response to new information; it would, in fact, simply make explicit an assumption already incorporated in the Bank’s May projections.

Labour market statistics released today are a mixed bag, showing stronger quantity developments than forecast by the MPC but surprisingly low earnings growth. Earnings weakness may not prevent the MPC from turning more hawkish, partly because it reflects sluggish productivity.

The unemployment rate fell to a below-consensus 6.6% over February-April, with the April single month estimate at just 6.45% – see first chart. This supports the forecast here that the rate will finish 2014 at 6.0% or below, undershooting the May Inflation Report projection of 6.3% in the fourth quarter.

The jobless rate is plunging because of strong demand for workers rather than US-style labour force weakness. Aggregate hours worked in the economy rose by 3.3% in the three months to April from a year before – the fastest annual growth rate since 1989. With the Inflation Report projecting a 3.6% GDP increase in the year to the second quarter, the suggestion is that productivity, as measured by output per hour, has barely budged. The MPC’s forecast of 1% productivity expansion in 2014, implying a larger rise in the year to the fourth quarter, is off track.

Annual growth in average earnings has been distorted by income shifting a year ago to game the cut in the top income tax rate from 50% to 45%. Taking a six-month moving average to minimise this distortion, earnings are rising at about a 1% annual pace. This is probably about 1 percentage point below the MPC’s expectation at this stage but, as noted, productivity is undershooting by a similar amount.

Part of the story is a shift of employment into lower wage / productivity activities over the past year. Earnings growth would be 0.5 percentage points higher in the absence of this composition shift.

The MPC may downplay earnings weakness partly because of the productivity offset but also because more timely survey evidence suggests rising wage pressures, while slack is eroding faster than expected. From employers’ perspective, the claim that significant slack remains is inconsistent with emerging skill shortages and a further rise in the vacancy rate to a six-year high – second chart.

The forecast of a summer rebound in global growth remains on track, according to the short- and longer-term leading indicators followed here.

The indicators are derived from OECD data and have led growth turning points by 2-3 months and 4-5 months respectively in recent cycles. They weakened during the second half of 2013, correctly predicting that the global economy would slow in early 2014. Six-month industrial output growth* peaked in November / December 2013 and fell to a 10-month low in April – see first chart.

The longer-term leading indicator, however, started to recover in January, with the short measure following in February. Industrial output growth is probably now reviving from a trough reached in May.

The short-term leading indicator rose again in April while the longer measure was little changed. This suggests that growth will pick up through the summer before stabilising at a higher level at the end of the third quarter.

The stalling of the longer-term indicator in April reflected a decline in the G7 component – second chart. The G7 measure may have been temporarily distorted by Japanese data volatility due to the recent sales tax hike; the April set-back, in other words, may be reversed in May-June. The E7 component, meanwhile, continues to strengthen, supporting optimism about emerging market equities.

The forecasting approach here uses the leading indicators in conjunction with an analysis of real narrow money trends. Global real narrow money expansion slipped back in April, but this mainly reflected the impact of the Japanese sales tax; trends elsewhere remained solid – see previous post. Global economic acceleration may be over by end-summer but the monetary / leading indicator evidence has yet to suggest a subsequent slowdown.

*G7 developed economies and E7 emerging economies.

The MPC lowered its unemployment rate projections again in the May Inflation Report but is probably still underestimating the speed of decline. The jobless rate may end 2014 at or below 6.0%, i.e. close to the MPC’s current central estimate of non-inflationary “medium-term equilibrium” of 5.8%.

The unemployment rate fell from 7.8% to 6.8% in the year to the first quarter of 2014 as GDP grew by 3.1%. The MPC expects GDP expansion to remain at 3.0-3.25% annualised through the fourth quarter. This suggests that the jobless rate will continue to decline by 0.25 percentage points (pp) per quarter, implying 6.0% by year-end.

The MPC, by contrast, forecasts that the quarterly fall will slow to 0.15 pp, yielding a 6.3% unemployment rate by the fourth quarter. This rests on an assumption that productivity growth will start to “mean revert” as the expansion matures. The same assumption was made in the February and November Inflation Reports but little recovery is yet evident. This is consistent with experience after the last major productivity “shock” in the 1970s, when performance remained weak for many years – see previous post.

Hopes of near-term productivity improvement are not supported by labour market leading indicators, which have yet to suggest any slowdown in employment gains or unemployment erosion. Six-month growth of the stock of vacancies, indeed, has risen further from 8% in October to 14% in April. The PMI services employment index regained its October peak in May – a 17-year high. The net percentage of consumers expecting a rise in unemployment, meanwhile, collapsed to a 16-year low last month – see chart.

These trends imply that productivity remains stagnant or else economic growth is even stronger than expected – either possibility, of course, would warrant greater inflation concern. Pressure for an early interest rate increase may continue to build.

The package of measures announced today by the ECB will probably have limited direct impact on money and credit conditions.

The ECB introduced new “targeted longer-term refinancing operations”, under which banks will be able to borrow from the ECB at a fixed rate for up to about four years to fund loans to the private sector, except for housing. The initial allocation of about €400 billion would allow an increase in the stock of such loans by 7%. The interest rate is fixed at the level of the main refinancing rate on take-up plus 10 basis points, i.e. only 0.25% currently. This is significantly more generous than the Bank of England’s funding for lending scheme (FLS). Unlike the initial FLS, however, it appears that banks will be required to hold additional capital against new loans. This, coupled with weak credit demand, may limit usage.

The ECB cut the main refinancing and deposit rates by 10 rather than the expected 15 basis points. It “intensified preparatory work” on buying asset-backed securities but has yet to make a formal decision to do so. The timing and size of any programme remain opaque. Decisions to extend fixed-rate full-allotment regular repos until at least end-2016, and no longer to sterilise bond purchases under the securities markets programme, were expected and are relatively insignificant.

The interest rate cuts are of net benefit to the banking system, since borrowing from the ECB significantly exceeds cash holdings. Cash-rich core banks, however, suffer at the expense of peripheral institutions with high borrowing and no excess reserves, although the amounts involved are small.

In his press conference comments, ECB President Draghi continued to dangle the carrot of an eventual US / UK-style QE programme. However, the Bundesbank’s support for today’s package, allowing Mr Draghi to trumpet a unanimous decision, may have been offered in return for keeping QE off the table for many more months.

The hope is that confidence effects from today’s announcements will be significant, while inflation will revive gradually as economic recovery continues. The latter scenario is plausible but monetary trends over the summer will be the best gauge of whether further ECB action will be required later in 2014.

Everyone, it seems, is positive about UK economic prospects. It is easy to be bullish when GDP has expanded solidly for four successive quarters, business surveys are strong and consumer confidence is hitting records. It was much harder in early 2013, when coincident indicators were weak and “triple dip” talk was fashionable. That was when a monetarist forecasting approach proved its worth.

The few economists who bother to examine the data know that real narrow money – specifically, non-financial M1* deflated by consumer prices – outperforms other money / lending measures as a leading indicator of the economy. This aggregate accelerated steadily through 2012 and was growing strongly by early 2013. The clear message was that the “triple dip” was nonsense and the economy would outperform expectations significantly in 2013.

So what is real narrow money signalling now? Six-month growth remains strong but has moderated in early 2014, with April’s reading the lowest since March 2013 – see chart. This suggests that GDP will continue to expand robustly through the third quarter but may slow slightly in late 2014.

Broad money, while less reliable, is also giving a benign message. Six-month growth of real non-financial M4, indeed, has moved slightly higher in 2014, though remains modest by historical standards. As previously explained, broad money trends are understating monetary laxity because falling deposit interest rates are depressing the demand to hold savings in monetary form. The velocity of circulation, in other words, is now rising**, implying that a given rate of broad money growth is more expansionary than in the past.

Credit trends contain little information about economic prospects. The six-month change in real non-financial M4 lending has recovered to zero in lagged response to faster GDP expansion. Arranged credit facilities – a leading indicator – do not suggest any imminent strong pick-up. The Bank of England, bizarrely, is considering “macroprudential” tinkering to restrict credit supply; it should focus, instead, on the inflation / asset bubble risks posed by monetary excess.
 
*Non-financial M1 comprises notes / coin and sterling sight deposits held by households and private non-financial firms.
**The ratio of nominal GDP to non-financial M4 (lagged six quarters) rose by 0.6% per annum between the second quarter of 2009 and the first quarter of 2014 versus a 3.2% pa decline over the prior 10 years.