HSBC comments on the labour market and monetary policy
Western central banks have become increasingly inventive with monetary policy. Their latest efforts involve tying the outlook for interest rates to unemployment to reinforce the commitment that rates will not rise until the economy is fully healed.
The general public understands unemployment figures, unlike some alternative targets. The idea is that people holding back on spending now for fear of losing their job know that if they do, the US Federal Reserve or Bank of England will keep their mortgage rate low.
But this "Roosevelt-style" communication strategy aimed at the citizen on the street has drawbacks. What if the central bank has incorrectly measured the rate of unemployment consistent with stable inflation? If the unemployment-rate goal is set too low, policymakers may get more inflation than they bargained for.
There are other problems: in particular, the pressure in the labour market – and therefore the potential for wage inflation – is not perfectly measured by the unemployment rate. Indeed, it is doing a particularly bad job of summing up the slack in labour markets because a significant part of the population is either under-employed or temporarily discouraged from actively seeking work.
US unemployment has fallen from a peak of 10 per cent in October 2009 to 7.3 per cent. This partly reflects a falling participation rate: people have given up looking for work because of the weak jobs market. But they may not have given up for good, and including those would-be workers would mean unemployment is really closer to 9 per cent.
When GDP improves, the despondent are generally tempted back into active search and thus again count as unemployed. The US has 11.3 million unemployed but a further 2.3 million on the sidelines. If the discouraged return to pre-crisis levels, it could take another year before unemployment falls to an acceptable level.
However, if part of the unemployment decline is structural and the despondent don't re-enter the labour force, the unemployment rate, despite falling, could still be accurately indicating the correct degree of inflationary pressure.
The UK has a similar demographic structure to the US with ageing baby-boomers and changing work preferences for women. Yet if anything, these groups are often described in Britain as putting upward pressure on the participation rate. Indeed, given the destruction of wealth caused by the financial crisis and increased longevity, the UK situation seems far more rational.
It's extremely hard to ascertain whether those not actively seeking work will change when the labour market improves and earnings pick up, but our suspicion is that many might.
The UK hasn't seen discouraged workers leave the labour market as the US has. Instead Britain has seen a massive shift into part-time work. This partly explains the UK "productivity puzzle" whereby unemployment rose much less than the decline in GDP would have implied.
So UK workers have taken what is available – shorter shifts and lower-paid jobs – to stay in work. The unemployment rate suggests the UK's labour market has remained far more buoyant than the US, yet British workers have had much less pricing power. Relative to the US, their real wages have been crushed.
Central bankers are supposed to safeguard a nation's real income – ensuring people are gainfully employed without excess inflationary pressures. But there are major issues with basing policy on the unemployment rate at this juncture because central bankers should be considering a larger pool of labour market information.
Taking a broader look at labour market slack we conclude monetary tightening is a considerable way off.