Low UK interest rates hinge on productivity rebound

LONDON (Reuters) - British workers’ productivity will need to rebound over the next couple of years or borrowers are likely to face an unexpected increase in the Bank of England’s interest rates.

The Bank of England is seen in the City of London August 7, 2013. REUTERS/Toby Melville

When new Governor Mark Carney said last week that interest rates would not rise before unemployment dropped to 7 percent, many home-buyers and business-owners will have banked on rates staying at a record low 0.5 percent for another three years.

But the central bank’s forecast that unemployment will take until at least late 2016 to sink to that level, from 7.8 percent now, hinges on a surge in how much workers produce an hour.

The plausibility of this jump in productivity is something many economists question after a historically unprecedented - and internationally unusual - 5 percent slump in Britons’ hourly output since the financial crisis.

“I firmly believe that the Bank of England will find themselves meeting the 7 percent (unemployment) threshold much earlier than they expect,” said Nomura economist Philip Rush, who predicts this will happen late next year.

“Whether they respond to that with tighter policy is still unknown. But we suspect they will,” he said.

Weak productivity would point the way to higher inflation - which the central bank’s remit still binds it to fight, despite its latest foray into forward guidance.

Unemployment rates are easy for statisticians to calculate and for the public to understand - a major reason why the Bank followed in the footsteps of the U.S. Federal Reserve in selecting it as a guide for its monetary policy.

But in Britain in particular, it is hard for economists to forecast, as the link between how much the economy produces and how many people are unemployed broke down after the financial crisis.

Britain suffered one of the sharpest falls in output for a major economy during the crisis, with gross domestic product shrinking by 7 percent.

Yet unemployment only rose from a pre-recession level of just over 5 percent to 8.4 percent at the end of 2011 - a far lower peak than the double-digit rates experienced in previous downturns and in other countries with smaller falls in output.

Since then, unemployment has dropped and the total number of people in work has reached a record level - despite the fact that output stagnated until the start of this year.

In sum, Britons’ productivity has suffered its lengthiest decline since records began in 1960.

The key assumption driving unemployment forecasts is what happens next to productivity - though other complications, such as forecasting the growth in part-time work and the size of the labour force also abound.


The Bank of England predicts the anomalous fall in productivity will reverse, ensuring that firms need to hire relatively few extra workers while growth picks up to its historic average of around 2.5 percent.

This is out of line with what happened to jobs in other recoveries, but this time may be different.

Some cyclical improvement in productivity is likely, as certain workers’ output per hour does automatically improve as demand strengthens - a classic example is an estate agent who finds it easier to sell homes in a stronger economy.

Another related reason is that some firms may have retained surplus workers during the downturn, rather than sacking them.

But for economists such as Rush, this is an insufficient explanation for the fall in productivity, as it was also caused by strong hiring during a period when economic data often suggested Britain was slipping back into recession.

“It’s one thing to argue that firms are holding onto staff to be in a better position for the recovery. It’s another thing to argue they actively went out and hired in anticipation of a recovery that they feared wasn’t about to come,” Rush said.

Instead this apparent paradox may be due to the fact that Britain’s financial services and oil and gas industries are no longer the cash cows they were before the crisis, and employment is shifting to more labour-intensive, slower-growth sectors.

It will be some time before it is clear who is right.

The Bank forecasts most of the fall in the unemployment rate will come in the next 18 months, and that unemployment will hover around 7.1-7.2 percent for the second half of its forecast period - an uncomfortable prospect for those waiting to see if interest rates will go up.

Economic data certainly suggests that the recruitment rate is accelerating, not slowing.

On Monday human resources executives said they planned to recruit staff at the fastest pace since 2008, and purchasing managers’ surveys earlier this month showed private-sector firms across the services, retail and construction sectors planned to hire at the fastest pace since 2007.

Data on Wednesday showed that employment rose by 69,000 in the second quarter of this year, and that the number of people claiming jobless benefit dropped by 29,200 in July, its biggest decline in more than three years.

Financial markets brought forward their expectations of a BoE rate rise after the figures, which coincided with central bank minutes showing that one policymaker had reservations about the forward guidance policy.

Whether the general public will also change their expectations of when interest rates will go up - or whether they think the central bank has in fact committed itself to leave rates on hold for three years - is another matter.

“You are giving people a false sense of security,” said George Buckley, UK economist at Deutsche Bank. “People don’t hear the caveats. So they may do something they will later regret if the Bank of England is forced to raise rates.”

Editing by Stephen Nisbet