A previous post argued that the MPC would need to set any unemployment rate threshold below 6.5% for markets to believe that current official rates will be held until 2015-16. It didn’t and they don’t.

The two-year-ahead forward rate on government liabilities – a gauge of market expectations of overnight rates in two years’ time – closed at 104 basis points yesterday, up from 90 bp last Tuesday, before the MPC’s forward guidance announcement. It is rapidly approaching a June peak of 121 bp – see first chart.

The spread between the two- and one-year forward rates is now 74 bp, above a June high of 71 bp. This suggests that markets expect official rates to be hiked by three-quarters of a percentage point between August 2014 and August 2015.

Labour market statistics released yesterday are consistent with the suggestion here that the unemployment rate will breach the 7.0% threshold by mid-2014, reflecting stronger GDP growth and slower productivity expansion than forecast by the MPC.

The rate was stable at 7.8% in the three months centred on May but the single month reading fell to 7.4% in June, a level also recorded in March, with April and May both at 8.0% – second chart. Put differently, the four- and two-month moving averages fell to 7.7%.

Unemployment must decline by about 250,000 to reach 7.0%. The claimant count – available two months before the official measure – fell by an average of 25,000 per month in the three months to July. This pace of decrease, if sustained, suggests that 7.0% will be hit in 10 months.

The fall in the claimant count is consistent with vacancies and survey data signalling a strong pick-up in labour demand. Vacancies surged by 8% in the six months to July, an increase historically consistent with six-month growth in employee numbers of 1% or more. 1% expansion equates to 250,000 new workers.

Strong demand for new workers casts doubt on the view of the MPC’s productivity optimists that firms have hoarded labour so will not need to recruit as the economy picks up.

The claimant measure captures only about 60% of total unemployment but may be a superior guide to trends because it is a comprehensive count. The official measure, by contrast, is based on a survey and is subject to significant sampling error. The Office for National Statistics estimates sampling variability at +0.3 percentage points (95% confidence interval).

The third chart shows two models designed to “predict” the official unemployment rate based on the claimant count; the second model includes a time variable to allow for trend divergence between the two measures. The models are used to project paths for the official measure assuming that the claimant count continues to fall by 25,000 per month.

The July claimant count reading is consistent with an official unemployment rate of 7.4% according to the first model; the second suggests 7.9%. Based on the assumed decline, the first model – the more optimistic – implies that 7.0% will be hit before end-2013. The second model, which incorporates a recent tendency for the claimant count to fall relative to the official measure, predicts August 2014.

The gap between the net-of-tax dividend yield on equities for a basic rate taxpayer and the net interest rate on a competitive bank / building society savings account stood at 1.90% in July compared with an average negative difference of 1.99% between 1954 and 2012 (i.e. 59 years). The gap was higher in only one quarter over this period – the first quarter of 2009, which marked the low of the 2008-09 equity bear market.

The wide gap reflects super-low interest rates rather than attractive equity prices – the net dividend yield is close to its long-run average. The higher income available on shares, nevertheless, could prompt a “great rotation” out of cash into equities, underpinning prices in the short run but exposing small savers to a medium-term risk of capital loss. Such a portfolio shift would imply that broad money supply expansion of as little as 4% per annum could be inflationary.

The chart shows the dividend yield on equities on an as-published basis and net of basic rate tax. The published yield refers to actual dividends paid since 1998; basic rate taxpayers are not liable for tax on such dividends* so the published and net yields are the same. Before 1998, the published yield was calculated on a gross basis, i.e. including a tax credit that was reclaimable by tax-exempt investors; the net yield applies the basic or standard rate of (dividend) income tax to this gross measure. The yield data refer to the FTSE all-share index from 1963 and the FT30 index for earlier years.

The deposit rate series links together interest rate data for bank / building society savings products that were competitive historically. The rate used in recent years is the average quoted rate on two-year fixed-rate bonds, sourced from the Bank of England. This series begins in 2009; the effective rate on one- to two-year household time deposits is used between 2004 and this date. Earlier figures refer to the average or recommended building society ordinary share rate.

The net dividend yield / deposit rate gap was positive in only 21 out of 216 quarters between 1954 and 2007, before the 2008-09 financial crisis. The gap of 1.90% in July compares with a record difference of 2.46% in the first quarter of 2009. Unlike now, equities were then cheap in absolute as well as relative terms.

Recent gap widening, of course, reflects a collapse in savings rates since summer 2012, due mainly to ECB and Bank of England interventions to reduce bank funding costs. The interest rate on two-year fixed-rate bonds, for example, fell from 3.17% to 1.80% between July 2012 and July 2013.

High deposit interest rates relative to inflation and yields on other assets contributed to a sustained rise in the ratio of the broad money supply to nominal GDP in the decades preceding the 2008-09 financial crisis. The velocity of circulation of money, in other words, fell steadily.

Recent unappealing savings rates have arrested this trend. The ratio of broad money, M4ex, to nominal GDP, for example, was unchanged between the fourth quarter of 2009 and the first quarter of 2013. With savings rates continuing to sink, the “equilibrium” M4ex / GDP ratio may embark on a sustained decline, as it did in the 1970s when real interest rates were last significantly negative.

On an optimistic view that the economy can sustain trend real growth of 2.5% over the medium term, nominal GDP expansion of 4.5% per annum is consistent with achievement of the 2% inflation target. If the M4ex / GDP ratio is stable, this implies target-consistent broad money growth of 4.5%. If the ratio declines, as seems likely, even this rate of increase will generate an inflation overshoot.

*More precisely, a tax credit of 10% offsets the 10% dividend income tax rate for such taxpayers.

The official preliminary estimate that GDP grew by 0.6% in the second quarter, or 0.62% before rounding, was based on projected rises in industrial and construction output of 0.6% and 0.9% respectively. The actual increases were slightly higher, according to data released last week – 0.65% and 1.4%. Industry and construction account for 14% and 6% of GDP. The upward revisions will add 4 basis points to the quarterly GDP rise, suggesting unrounded growth of 0.66%, or 0.7% rounded.

This change could be magnified, or indeed offset, by a revision to the current estimate that services output – accounting for 79% of GDP – grew by 0.6% last quarter. This estimate assumed that services activity contracted by 0.1% in June, after gains of 0.3% and 0.2% respectively in April and May. The services PMI activity index, by contrast, strengthened in June (and July). June services output, like the GDP revision, will be released on 23 August. Services turnover, however, feeds into the output calculation; a June update will be available on Friday.

A post in June suggested that Chinese economic prospects were improving slightly, based on stable, respectable real money expansion and a recovery in the “official” manufacturing purchasing managers’ survey. The official PMI is judged here to be more informative than the Markit / HSBC version, which was – and remains – weak.

July figures confirm that activity has firmed modestly – six-month growth in industrial output* recovered to 4.3% (not annualised) from a recent low of 3.3% in April.

This “good” news, however, is tempered by disappointing July monetary data. The six-month rates of change of real (i.e. inflation-adjusted) M2, M1 and broad credit (i.e. “social financing”) all fell last month – see chart.

Real M1 is accorded greatest weight here; its six-month change turned negative in July. This partly reflects an unfavourable base effect but is nonetheless concerning, suggesting that the mid-year spike in money market interest rates has damaged confidence and spending prospects.

Money market rates have since normalised but remain significantly higher than during the first half.

Chinese activity may lift further near term as the global economy strengthens – see previous post. The danger is that the authorities use such a pick-up as an excuse to delay monetary easing, without which the economy will be vulnerable if the global cycle turns down in early 2014.

*Based on a seasonally-adjusted levels series estimated from official data.