CPI inflation is expected here to fall further through early 2014, undershooting the MPC’s forecast significantly, before rebounding later next year and in 2015 in lagged response to recent monetary buoyancy and associated economic strength. The near-term decline may allow the MPC to claim that the “inflation-growth trade-off” (a questionable concept) is more favourable than it had assumed, implying that Bank rate can be held at 0.5% even if the unemployment rate falls well below its (current) 7% threshold.

CPI inflation eased from 2.8% in July to 2.7% in August, while the core measure monitored here – which excludes energy and unprocessed food and adjusts for changes in VAT and undergraduate tuition fees – was stable at 2.0%. The core rate has trended lower since early 2012 in lagged response to a slowdown in monetary growth in 2010-2011 – see previous post for details.

The core downtrend is scheduled to continue into the autumn and may be reinforced by recent sterling strength. Coupled with smaller rises in energy and unprocessed food prices than a year before, this may result in CPI inflation falling to 2.25-2.5% in early 2014 versus a current MPC central projection of 2.89% for the first quarter of next year.

Core inflation, however, is forecast here to embark on another upswing from late 2013 in lagged response to a sustained pick-up in monetary growth from late 2011. Incorporating assumptions about energy and food prices detailed in the prior post, this implies that CPI inflation will move significantly higher from spring 2014, probably exceeding 3.0% during the second half of next year. The first chart below shows projections for headline and core inflation while the second compares the former with the MPC’s forecast.

The suggestion is that the MPC’s policy stance will be exposed as having been much too accommodative in mid-2014, with the unemployment rate at or close to the 7.0% threshold and inflation rebounding strongly. Monetary conditions may then be tightening in response to higher market yields and as faster inflation squeezes real money supply growth. Belated hikes in Bank rate would not prevent a further rise in core inflation in 2015 – already baked into the cake by recent monetary trends – but would increase the probability of another economic downswing in 2015-16.

Such a scenario would imply that, by failing to respond in a timely fashion to monetary signals, the MPC has once again served to magnify rather than moderate underlying economic volatility. Such mismanagement, in turn, deters businesses from making the investment commitments needed to boost long-run potential growth.

UK productivity – output per hour worked – is currently 15% below an extrapolation of its trend over 1998-2008. Productivity rose at a trend rate of 2.3% per annum (pa) over this period; since 2008, by contrast, it has fallen by 1.0% pa – see following chart.


The Bank of England’s Monetary Policy Committee (MPC) forecasts that productivity will recover by 1.8% pa over the next three years. Many commentators regard this as unduly pessimistic, since it implies that 1) the 15% loss relative to the prior trend is permanent and 2) future trend growth will be below the historical average.

The judgement here, by contrast, is that the MPC's forecast is optimistic. This is based partly on an analysis, summarised below, of the last major productivity slowdown, in the 1970s. The weaker productivity performance expected here informs the view that unemployment will fall more rapidly than the MPC expects while “core” inflation will pick up in 2014-15.

The 1970s analysis is based on output per worker rather than output per hour because the former has a longer data history. Inspection of the data reveals a strong productivity trend in the decade to 1973, much slower growth between 1973 and 1980 and a return to faster expansion in the 1980s – next chart.


The change in trend in 1973 coincided with the onset of the “first oil shock” recession, which had similarities to the 2008-09 downturn – it was preceded by extreme monetary / credit laxity and precipitated a financial crisis; a spike in energy costs, moreover, contributed significantly to the 2008-09 recession.

A key difference from the recent past is that productivity continued to grow in the mid to late 1970s. The divergence from the prior trend, however, was substantial. Trend productivity growth slumped from 3.3% pa over 1963-1973 to 1.4% over 1973-1980, a reduction of 1.9 percentage points (pp). This compares with the recent decline of 3.3 pp (i.e. from 2.3% to -1.0%). By 1980, productivity was 16% below the prior trend – similar to the current 15% shortfall.

Several features of the 1970s experience are discouraging to current productivity optimists. First, the period of weakness lasted seven years, which, if repeated now, implies no recovery until 2015. The optimists, presumably, would argue that the larger deterioration in recent years increases the likelihood of an earlier revival.

Secondly, while productivity recovered after 1980, growth was permanently lower than before 1973. There was no catch-up relative to the prior trend. Trend growth over 1980-1990 was 2.5% pa, 0.8 pp below that in the decade to 1973. A similar step down now would imply future expansion of 1.5% pa (i.e. the 1998-2008 trend of 2.3% pa minus 0.8 pp).

The 1980s productivity revival, moreover, occurred only after another – deeper – recession and was at least partly due to economic liberalisation under the Thatcher government. The 1980-1981 downturn forced companies to shed low-productivity workers, whose jobs had been shielded by the loose monetary / fiscal policies of the 1970s. The Thatcher reforms, meanwhile, resulted in a more efficient allocation of capital and labour.

Current and prospective faster economic expansion should allow productivity to recover but the working assumption here is that growth will be 1.0-1.25% pa in the absence of policy changes to improve economic efficiency. If GDP rises by 2.5-2.75% pa, and the labour force expands in line with the MPC’s projection, this would imply a decline in the unemployment rate of about 0.75 pp pa – consistent with it reaching 7.0% in mid-2014.

The optimists believe that productivity growth will “mean revert” without any policy intervention, resulting in unemployment staying high. The 1970s-1980s experience suggests that causation is the other way round – a normalisation of productivity expansion may occur only as a result of policy changes that promote a reallocation of resources and push unemployment higher in the short term.

A scenario regarded as plausible here is that, with productivity performance remaining weak, faster growth will run into capacity and inflation constraints in 2014-2015; an associated tightening of monetary conditions – probably market-led rather than due to the MPC – could then produce another economic downswing in 2015-2016. Depending on its extent and policy choices, this downswing – like the 1980-1981 recession – could act as a catalyst for a more significant and durable improvement in productivity growth.

Monday’s post argued that a positive view of the global economic cycle should be maintained until either global real narrow money expansion slows further or the longer leading indicator calculated here turns down. Available monetary data suggest that six-month growth of G7 plus E7 real narrow money rose in August, partially reversing a decline in June / July – see chart.

August statistics have been released by the US, Japan, China, India and Brazil, together accounting for about 60% of the G7 plus E7 aggregate. The recovery in growth was entirely due a rebound in Chinese real M1 following weakness in July – see Tuesday’s post. The final August reading will depend importantly on Eurozone data, released on 26 September.

Slightly weaker real money expansion since the spring suggests that global economic growth will moderate around year-end, while remaining respectable – a benign scenario, in theory, for markets.

Construction and industrial output figures released this week confirm that both sectors started the third quarter strongly while suggesting that second-quarter GDP growth will be revised up from 0.7% to 0.8%.

Construction output in July was 1.4% above the second-quarter level, while industrial production was 0.9% higher. Even assuming no further increase in August and September, the two sectors would contribute 0.2 percentage points to third-quarter growth, based on GDP weights of 6% and 14% respectively.

Second-quarter growth was estimated at 0.72% in the last GDP report but increases in construction and industrial output have since been revised up by 0.5 and 0.1 percentage points respectively. The combined impact on GDP growth is 4 basis points – sufficient to push it up to 0.76%, or 0.8% after rounding, assuming no change in the current estimate of services expansion. Services output may also be revised up, reflecting the normal tendency for statisticians initially to underestimate activity in economic upswings.

The improvement in construction prospects was underlined by a 19.7% surge in new orders in the second quarter, suggesting that new construction output will return to 2010-11 levels – see chart. This would entail a rise of about 10% from the second quarter, implying a GDP boost of 0.4%, based on the 4% weight of new construction (with repairs and maintenance accounting for the remaining 2 percentage points of the total 6% weight of construction).

Today’s strong labour market numbers support the forecast here that the unemployment rate will fall beneath the MPC’s “threshold” by mid-2014. They also imply that productivity performance remains disappointingly weak.

The labour force survey (LFS) measure of the unemployment rate fell to 7.7% (7.69% before rounding) in the three months to July from 7.8% in the prior three months. LFS unemployment needs to decline by 20,000 per month for the rate to breach 7.0% by mid-2014. This looks eminently achievable: claimant-count unemployment leads the LFS measure and fell by 33,000 per month in the three months to August.

LFS employment has been growing solidly but, in addition, there has been a substitution of full- for part-time jobs. Aggregate hours worked, therefore, rose by 0.8% in the three months to July from the prior three months. With GDP currently estimated to have increased by 0.7% in the second quarter, the suggestion is that output per hour is continuing to slip – at odds with the MPC’s view that productivity performance would recover as the economy strengthened.

A post in June expressed modest optimism about Chinese economic prospects. August data confirm that activity has firmed: six-month growth in industrial output rose to 5.4% (not annualised) from a recent low of 3.3% in April.

Monetary trends, however, caution against extrapolating this improvement. Six-month rates of change of real M1 and M2 recovered in August but remain lower than in the spring – see chart. Real bank lending has been growing faster but has been boosted by “reintermediation” due to a clampdown on off-balance-sheet and non-bank credit; real social financing – a broad credit measure – has slowed.

A stronger global economy should support exports and industrial activity over the remainder of 2013 but sluggish monetary trends suggest subdued domestic demand and moderate overall expansion.