Standard Life Investments

Weekly Economic Briefing


Global Overview - Back to work

It has been a long slog. The labour market fallout in the wake of the global financial crisis proved to be painful, pervasive and persistent. However, there are signals that after almost a decade, the healing process is close to completion. Our in-house indicator of labour market slack across developed markets tells this story well. The downturn opened significant spare capacity across labour markets, and it took years before economies started to chip away at this slack. Following consistent and relatively steady inroads, a wide range of developed market economies are now at, or approaching, labour market conditions similar to those prevailing before the crisis. This certainly looks true of the US, Canada, Australia and the UK. In the Eurozone, the German labour market looks tighter than in 2008, although Spain, France and Italy are all lagging. The story in emerging markets is more nuanced. Data quality issues in China make it difficult to estimate slack, but there have been signs that the acceleration in activity over the past year has clearly fed through to the labour market. There have been fewer signs of progress in Brazil and Russia, which are still in the early stages of recovery from deep recessions. However, we are seeing unemployment rates creep lower across a range of smaller emerging economies.

Against this backdrop, it is not a surprise that central banks are starting to turn an eye toward removing policy accommodation. However, there is a catch. Despite labour market progress we have yet to see concrete evidence that economies are producing inflation in line with central bank targets. There could be a straightforward explanation for this disconnect, such as transitory factors dampening inflation, or delays between closing labour market slack and building wage pressures. Alternatively, slack could be larger than we, and central banks, believe; or sector-specific structural factors could be a more permanent headwind to inflation. Most malign would be if firms and households had lost faith in central banks inflation targets following serial disappointments. This inflation puzzle will take time to decipher, but should not prevent central banks starting to adjust policy. However, it should make them cautious with regards to the speed at which they can withdraw. Data dependence will be the watchword for policy in 2018.  

Time to fire the starting gun?
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USA - Underlying strength

According to preliminary estimates, non-farm payroll employment fell 33k in September, an outturn that would ordinarily put policymakers and markets into a spin. However, this was no ordinary month. Thanks to hurricanes Harvey and Irma, almost 1.5 million people were estimated to have been unable to get to work during the survey week, significantly distorting the figures. Indeed, when we take this and the other components of the report less distorted by weather effects, the message was much more bullish, and reinforces the picture of an economy growing faster than its potential. Both headline unemployment (4.2%) and under-unemployment (8.3%) rates fell to new cycle lows, with the former declining to its lowest level since December 2000. This progress came in spite of an increase in the participation rate, reinforcing the nascent signs that discouraged workers are gradually being drawn back into the labour force. Taken together, declining unemployment and rising participation lifted the employment-to-population ratio by 0.3 percentage points (ppts), its highest level since January 2009 when the fallout from the financial crisis was still gathering force.

Full employment? Gradually building wage pressures

The continued rise of labour utilisation rates begs the question of whether labour market slack has now been eliminated. For example, Federal Open Market Committee members currently think the long-run equilibrium unemployment rate is somewhere between 4.4% and 5%, suggesting that the economy is already at, or beyond, full employment. OECD and Congressional Budget Office staff also think the structural unemployment rate lies within this range. Other indicators, however, imply that some slack may still exist. The U6 measure of labour underutilisation, which takes into account marginally attached workers and those working part-time for economic reasons, fell as low as 7.9% in the last cycle, while at 78.9%, the employment ratio of prime-aged workers (those aged 25-54) is still 1.5 ppts below the peak of the previous cycle (see Chart 2). Some of that shortfall probably reflects structural factors, including the impact of the opioid crisis, but how much is still highly uncertain.

The typical way to resolve questions around slack is to examine the trajectory of wages and unit labour costs. Those in the camp that slack has been eliminated would point to the fact that average hourly earnings increased 0.5% in the month of September, sending the year-on-year growth rate to 2.9%, its strongest since June 2009. Yet these data too may have been distorted by hurricanes and wage growth of private sector production and non-supervisory workers still lies within its range of the past two years. Meanwhile, there is little evidence of accelerating wage growth in the employment cost index, or the Atlanta Fed’s wage growth tracker, and unit labour cost growth has actually been decelerating (see Chart 3). The transmission of changes in labour market slack into labour cost measures is of course long and variable, but there is not an open and shut case that the economy is running hot and that a wage and inflation breakout is imminent. The upshot is that although the Federal Reserve has more than enough ammunition to justify lifting the federal funds rate again in December, we still think that underlying inflationary pressures are likely to build only gradually and hence the pace of monetary policy withdrawal will remain very gradual.

Jeremy Lawson, Chief Economist

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UK - Taking the shine off

The headline coming out of the UK labour market seems at first glance to be encouraging. The unemployment rate is sitting at a 40-year low at 4.3%, and has almost halved since its peak in 2011. Our labour market slack indicator, which measures the gap between current unemployment at its equilibrium rate, provides another way of observing this progress (see Chart 4). The recovery has been driven by strong job creation, and this has continued of late, with fears that uncertainty might hold back hiring not materialising. Employment growth is currently running around a healthy 1% in year-on-year terms, with the majority of this representing full-time, private sector jobs. This has been outpacing the still-solid growth we are seeing in labour supply. The labour force has been boosted by both a rise in the working age population and the participation rate to a record high. Interestingly, we have already seen a slowdown in the growth rate of EU nationals employed in the UK since the referendum last year. However, it is too early to draw any strong conclusions around what Brexit might mean for future EU migration flows at this stage, with even the details around current resident rights after the Article 50 deadline and beyond not yet agreed upon.

Running out of room Doing less with more

The good news story starts to falter when we take a step back to look at the broader economic environment. A clearly tightening labour market has come in spite of a slowdown in economic activity over the course of 2017. The upshot of this unusual dynamic has been further disappointments on the productivity side. The Office for National Statistics this week released updated figures which underline productivity challenges. Labour productivity (output per hour worked) fell in both Q1 and Q2 of this year, with much of the weakness concentrated in the production industries. While this may have been exacerbated by cyclical factors, the longer-term trend is alarming. Indeed, when we look across its peers the UK fares very poorly in comparisons of labour productivity (see Chart 5). The concern is that a seeming reluctance of businesses to invest amid current uncertainty over EU membership could be exacerbating this underperformance. Therefore, while it is positive that employment is rising as people get jobs, the weak productivity backdrop takes the shine off these dynamics.

There are a number of reasons why the UK’s productivity woes matter so much. Productivity growth is critical for raising real per capita incomes in an economy. Indeed, a good portion in the weakness in pay growth over recent years reflects productivity struggles. Bank of England Governor Carney has flagged that monetary policy can do little to alleviate this problem. Instead, weak productivity and potential growth are likely to mean that the Bank is forced to raise rates sooner rather than later, with spare capacity seemingly eliminated. The chancellor will also be contemplating these data with a degree of trepidation. If the Office for Budget Responsibility marks down its expectations for potential growth in response to these latest setbacks, fiscal policy will need to be tighter to hit deficit targets. At least the government can do something about the productivity challenge. More aggressive action is needed to boost growth and we would advocate a rewriting of overly restrictive fiscal rules in order to create room for targeted investment in infrastructure and skills.   

James McCann, Senior Global Economist

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Europe - Reading between the headlines

Eurozone labour markets continue to heal. At the aggregate level, the unemployment rate came in at 9.1% in July, having gradually fallen from a post-crisis high of 12.3% in the summer of 2013. Meanwhile, the other side of the coin – the overall employment level – also reflects this recovery, with the number of people employed having finally risen above the pre-crisis peak in Q1 this year. However, we frequently point out that the aggregate figures in the Eurozone risk overstating the state of play in the individual labour markets. For Germany, the unemployment rate sits much lower than the aggregate at 3.6%; the result of a steady fall in unemployment following only a minor surge in 2008. However, Germany is the exception rather than the rule; for many Eurozone countries, particularly in the periphery, unemployment rates are much higher. Indeed, Spain and Greece remain in recovery mode, with unemployment having peaked at 26% and 27% respectively at the height of the crisis, and still sitting well above the aggregate measure at a chronic 21% and 17%, according to the latest print.

Wasted youth Redefining slack

Headline unemployment rates are not the only game in town. Indeed, it may well be that alternative measures of labour market health can give us an insight into the difficulties facing the Eurozone, both economically and politically. For example, Eurozone youth unemployment sits higher at 18.9%, having fallen only gradually from post-crisis highs of 24.7%. Again, regional disparities emerge; with Italian, Spanish and Greek youth unemployment standing out at 35%, 38.7% and 42.8% respectively (see Chart 6). While this represents an improvement on these member states’ post crisis highs, still-elevated youth unemployment rates are problematic in two ways. Firstly, high youth unemployment can affect future labour market dynamics as young people in the workforce risk becoming discouraged at a time when they should be accumulating skills. This can weigh on future labour market participation and human capital. It can also feed the second risk: political dissatisfaction and Euroscepticism. While trust in the European Union (according to the Eurobarometer survey) has increased as the recovery has progressed, it remains lower than pre-crisis levels. The future of the union requires buy-in from younger voters who will drive the agenda in future.

Also, while unemployment rates have come down substantially alongside the recovery, structural unemployment rates have likely declined too. Structural reforms undertaken across a number of Eurozone member states in the wake of the crisis can help increase labour market efficiency and reduce the structural rate of unemployment in the economy. Indeed, these reforms may be restraining wage growth as they support the supply of labour, reduce collective bargaining and provide greater firm-level wage flexibility. Finally, headline unemployment rates may not be telling the whole labour slack story either. ECB economists have noted that the U6 measure of labour underutilisation – which includes marginally attached and underemployed individuals – provides a more holistic picture of labour market pressures. This is almost double headline unemployment and well above pre-crisis rates, suggesting slack is even greater than appears at first blush (see Chart 7). Given these dynamics, policymakers should tread carefully as they pursue policy normalisation in the new year.

Stephanie Kelly, Political Economist

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Japan & Developed Asia - Caught short

The unemployment rate is typically a useful guide to labour market conditions. In Japan, it has dropped to a 23-year low, having roughly halved since its 2009 peak. However, is the strength of this signal corroborated by other labour market data? Let us first look at evidence to assess labour demand. Last week’s Tankan survey pointed to acute labour shortages, with the employment conditions diffusion index printing at -28 (negative score is insufficient), a 3-point fall from the June survey. Furthermore, job openings are at a record high, with the number of opening across the country 1.52 times the number of applicants. Other important labour metrics are less buoyant. Total hours worked has continued to fall, suggesting the intensity of labour usage is declining (see Chart 8). In addition, labour costs data remain subdued. Basic wages continue to trend between 0-0.5% y/y, rising 0.4% y/y in August, while real wage growth is closer to zero. These conflicting signals present a problem for assessing the overall health of the labour market. The hours worked data appear to reflect structural changes in labour demand as employers, particularly SMEs, have been shifting to a five-day working week since the early 2000s. In addition, the increase in the part-time worker ratio has also been at play. However, to understand the wage cost trends one needs to delve deeper into the labour supply dynamics.

A sustainable improvement? No golden pension pot

One of the most striking changes in the Japanese labour supply in recent years has been the revival in the participation rate since 2012, compared to the previous decade and a half of falling participation. This reflects perhaps one of the most powerful achievements of Abenomics – the mobilisation of Japan’s elderly workforce (see Chart 9). Indeed, the participation rate of those over 65s has risen by nearly 5ppts since 2011. This reflects the appointment of a new Minister for Promoting Dynamic Engagement of All Citizens in Abe’s cabinet, who has been tasked with attracting senior citizens, as well as women, into the labour market. A key question is: can the pace of participation improvement be sustained? This depends on the scale of surplus labour. Based on senior participation rates, Japan compares reasonably well to the OECD average but has some way to go until it reaches the 31.5% participation of over 65s in Korea. Despite recent improvements, its female participation rate is still below the OECD average. Furthermore, the workstyle reforms scheduled to be legislated early next year are likely to further dismantle corporate compensation practices that favour full-timers while also improving work-life balance. Consequently, we think the adjustment of Japan’s labour markets in terms of improving non-regular workers appears to be just beginning.

Another potential source of labour supply comes from overseas. While the ratio of overseas workers to total workforce is still low at around 1.6%, it jumped 20% last year –  topping the symbolic one million mark. There are few signs of this slowing soon with policymakers calling for a doubling of the size of this workforce. Furthermore, strict visa criteria for service sector employees within strategic special zones is set to be relaxed, attracting tourism, retail and restaurant workers from overseas. Given this background, we suspect expanding labour supply will continue to dampen wage pressures.

Govinda Finn, Japan and Developed Asia Economist

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Emerging Markets - Workers still in the driving seat

The Chinese labour market has tightened noticeably over the past year, owing to an improved external environment and a pick-up in industrial sector demand. A few interesting trends emerge among the data. First, rebalancing and industrial upgrading is evident in the employment data, with electronics and environmental industries continuing to show gains in employment. Second, income growth has improved, largely due to direct government transfers and housing-related income (see Chart 10). Third, the industrial rebound and supply-side policies have provided direct support to embattled western provinces, where much mining and heavy industry is based.

Growing rural transfers Tight labour in Western China

What is the data telling us? China’s official unemployment rate is uncannily steady, having hovered between 4% and 4.5% for the last decade. Despite its “steadiness”, it can still reflect general trends in the labour market. In this vein, the unemployment rate has dropped below 4% for the first time in over a decade, registering 3.95% in Q2. The ratio of job openings to job seekers is another data point that can help form an outline of the broader trend. This ratio has been on a broadly improving trajectory since 2015, but the regional breakdown provides more interesting insight. By region, eastern China and central China show stable ratios; however, this contrasts with western China which shows a labour market that continues to tighten (see Chart 11). This suggests that policies meant to move economic activity further inland from the coast are having an effect. In addition to an improved growth outlook, direct policy support is also bettering the outlook for migrant rural labourers – government transfers to rural workers are accelerating and grew 13.5% in Q2 as part of the government’s wealth redistribution and rural support goals. Following the Party Congress, we expect Xi to continue supporting rural wealth redistribution, both through favourable housing policies but also through larger direct income transfers.

The health of the labour market has been, and will continue to be, one of the main drivers of economic policy. Stimulus, both when and how it’s delivered, is largely responsive to the labour market. For example, supply-side policies were mainly a response to economic stress in western and northeast China. Likewise, as wage growth accelerates and the labour market tightens, authorities are wisely taking this opportunity to raise interest rates and push financial and corporate deleveraging. However, the rapid improvement in the labour market also raises other concerns. On a recent trip to Beijing, economists expressed concern about the recent pace of income growth. Furthermore, despite the recent improvement, policymakers will continue to face difficult structural issues. Although there is generally less pressure to create jobs than in the near past, will new sectors be able to add enough jobs to absorb displaced workers as old industrial sectors continue shed jobs and higher wages push manufacturing jobs to Bangladesh and Vietnam? Lastly, will the economy be able to produce enough jobs to employ the millions of new graduates produced by Chinese universities every year? Indeed, the swelling ranks of graduates looking for suitable work may be the next driving force behind liberalising reforms.

Alex Wolf, Senior EM Economist

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