The economic surprises of 2013 were the strength of growth from the spring and the speed of the decline in unemployment later in the year. Both had been suggested by a monetarist forecasting approach*. Better news has contributed to the consensus GDP growth projection for 2014 moving up to 2.8%**, close to the expectation here of “about 3%” based on monetary trends.

The next surprise could be a strong pick-up in wage and price pressures in late 2014 and 2015. This would fit with a two-year lead from money growth to inflation, as well as evidence that the economy is now operating above non-inflationary “potential”. The vacancy and short-term unemployment rates***, in particular, have moved through longer-term averages, indicating that labour market conditions are tight by historical standards. Real earnings growth is inversely correlated with the short-term jobless rate; it is much less sensitive to longer-term unemployment – see first two charts below.

Rising wage risks are confirmed by today’s Recruitment and Employment Confederation (REC) jobs report, showing that candidate availability is falling at the fastest pace for 10 years, with corresponding strong upward pressure on starting salaries for new permanent recruits. The final chart is taken from a recent speech by MPC member Ian McCafferty; the REC permanent salaries index climbed further last month and is close to the highs reached in 1998 and 2007. Whole-economy earnings growth is forecast here to rise to about 4% by the May 2015 election, contributing to the Conservatives moving into a poll lead versus Labour – see previous post.

*See, for example, here and here.
**Treasury survey of forecasters, April 2014.
***Short-term = unemployed for up to six months.

The OECD claims that UK house prices “significantly exceed long-term averages relative to rents”. Really?

The OECD calculation compares the ONS house price index with the rents component of the RPI. These measures, however, are based on different “baskets” of houses. The OECD is comparing apples with pears.

Specifically, the ONS house price index is a value-weighted measure (i.e. giving greater weight to expensive houses) based on a survey of mortgage-financed transactions. It excludes public sector housing.

The RPI rents index, meanwhile, measures actual payments by tenants in both the private and public sectors. It is implicitly weighted towards lower value housing. Public sector rents (i.e. paid to housing associations and local authorities) account for nearly two-fifths of the index.

A far superior methodology is to compare national accounts data on aggregate rents – both actual and imputed to owner-occupiers – with the value of the housing stock. Assuming that the statisticians use appropriate methods for imputing owner-occupied rents, the two parts of the ratio will reflect the same mix of housing.

This national rental yield measure is regularly calculated here and signalled that house prices were about 30% overvalued at their peak in 2007 but had moved to significant undervaluation by end-2011. This contrasts with the OECD's claim that the price to rent ratio has remained above average in recent years.
 
What is the current message? The national rental yield was an estimated 4.52%* at end-2013 versus an average since 1965 of 4.26%, implying 6% undervaluation. Recent house price strength, in other words, has not been excessive relative to housing market “fundamentals”, which have simultaneously driven up rents.

Houses are expensive in terms of earnings but bubbles are characterised additionally by an overshoot of prices relative to rents, as rose-tinted perceptions of capital gains potential distort assessments of the merits of owning rather than renting. Current prices are still far from bubble territory, though could get there if monetary conditions remain excessively loose.

*The yield is calculated on a trailing 12-month basis, e.g. its end-2013 value equals rents in calendar 2013 divided by the December housing stock . The latter was estimated by linking the published end-2012 value to the change in the ONS house price index between December 2012 and December 2013.

The latest Fed and ECB bank lending surveys are consistent with the forecast here of solid global economic growth through late 2014.

The net percentage of banks easing credit standards on loans to smaller firms* tends to lead the economic cycle, though is less informative for forecasting purposes than real narrow money trends. The Eurozone indicator turned heavily negative ahead of the 2008 recession and rebounded before the 2009 recovery – see first chart. Behaviour around the 2011-12 recession was more coincident than leading (in contrast to real narrow money). The latest reading is consistent with respectable economic growth**.

The corresponding US series has a longer history and has correlated similarly well with the economic cycle, with the latest result again solid – second chart.

The forecast that six-month global industrial output growth will rise from a short-term low in May through late 2014 rests on faster real narrow money expansion since late 2013 and a more recent recovery in the longer leading indicator followed here. A final March reading of the leading indicator will be available on 13 May, with preliminary data suggesting another monthly increase – see previous post.

*Net percentage easing = net percentage tightening multiplied by -1. Larger firms are less reliant on bank lending.
**Eurozone banks are also asked whether they expect to ease standards next quarter; the net percentage was stable at a seven-year high in the latest survey.