Weekly Economic Briefing

09 May 2017


Global Overview - The big payback

The latest jobs report in the US again brought into focus the strength of US labour demand. With the unemployment rate below estimates of the long-run average, sinking to 4.4% in April, it is hard not to conclude labour is in short supply. However, wage growth remains curiously subdued. It is not an isolated phenomenon either, with developed markets wage growth stubbornly low (see Chart 1). One argument is that labour markets may not be as tight as one would casually conclude. Although markets typically seek evidence on supply and demand dynamics to assess labour market conditions, the absolute level of spare labour capacity in the economy reflects the ability of an economy to utilise its entire population. Excluding those below working age, there is a wide range of factors that can influence the use of labour, with certain cohorts subject to significant changes in participation. Central banks typically make assumptions about available labour supply based on historical averages. However, in a world where technological and medical advancement is leading to changing workforce participation trends in developed economies, it is possible that the margin for error regarding estimates of NAIRU is wider than assumed.  

That said, if labour markets continue on the current trajectory, will the issue of measurement inaccuracies prove purely academic? Not necessarily. Weak wage growth may also reflect more enduring structural factors. One such force is increasing competition from machines. While humans have always worked in concert with technology, its benefits can be distributed unevenly. Empirical evidence suggests recent technology innovation is increasingly capital-biased, possibly serving as a drag on labour's share of total income. Heightened competition from machines is not the only worry. The removal of barriers to international trade and capital flows has raised aggregate income levels across the globe, but there is evidence it has eaten into the earning power of key income segments. Furthermore, international wage competition may reduce the influence of domestic factors in wage-setting behaviour. On balance, we think policymakers may need to run economies 'hotter' than in the past given these hurdles. However, wage pressures will eventually rise if labour market trends continue.

Earning power cut
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US - Wage swings and roundabouts

Each time the monthly increase in non-farm payrolls has slipped to 100k or below over the past four years, the following month has shown a gain of at least 200k. That pattern was on display again in April, as the weak March print of 79k was followed by an increase of 211k. Looking through the 'noise', the six-month moving average of payroll gains edged up to 176k, which is well below the peaks seen through 2014, but more than enough to continue reducing labour slack. Unsurprisingly then, labour utilisation rates continue to improve as well; the unemployment rate fell to a new cycle low of 4.4% in April, as did the broader U6 measure labour underutilisation that includes marginally attached workers and those working part-time for economic reasons (see Chart 2). At 60.2%, the employment to population ratio is now at its highest level since February 2009. The healthy April report will have reinforced the conviction expressed by Federal Open Market Committee (FOMC) members in last week's meeting statement that the weakness of economic activity in the first quarter was likely to be transitory. As a result, the probability that FOMC members will vote to increase the federal funds rate by another 25 bps in June is currently sitting at 95%.

Approaching full employment
Subdued cost pressures

Further out, the path for Federal Reserve (Fed) policy will be more dependent on the path of underlying inflation. Core PCE inflation – the measure targeted by the Fed - dropped back to 1.56% in March, which was the weakest outcome since March last year and still 0.44 percentage points (ppts) below the Fed's target. Indeed, there are now probably downside risks to the Fed's median end-year core PCE inflation projection of 1.9%. When assessing the outlook for underlying inflation, we take into account a range of factors such as the domestic labour utilisation gap, recent movements in the exchange rate, the strength of global activity and external price pressures, and the growth in domestic labour costs. The latter is especially important and the evidence that labour cost pressures are mounting remains mixed. Private sector average hourly earnings increased 0.27% in April, but the six-month annualised growth rate fell back to a 14-month low of just 2.25%. The 0.8% Q1 increase in the employment cost index (ECI) – which we regard as a better measure of labour-cost growth because it controls changes in the composition of the labour market – was the strongest quarterly outturn since Q4 2007. However, that was partly due to the largest increase in accommodation and food services (1.8%) in the history of the series and may have been strongly influenced by widespread increases in state and local minimum wages; the Q2 data will give us a better sense of the underlying trend in ECI growth. The other measure of wage growth we like is the Atlanta Fed's Wage Growth Tracker. That shows that although the three-month average median gain has come down from its November cycle peak, the 12-month median gain has stayed elevated at 3.5%, with wage growth among prime-age, university educated, high-skill and full-time workers continuing to trend up. Meanwhile, although the year-on-year (y/y) growth rate of unit labour costs, which adjusts increases in compensation per hour for the growth rate in productivity, picked back up to 2.9% in Q1, the trend has been fairly flat in recent quarters and there is very little growth in unit non-labour payments at present (see Chart 3). We still expect the ongoing reduction in labour slack to put some upward pressure on labour cost growth, but there is little sign of an imminent break-out.

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UK - Still waiting on a raise

The UK labour market has slowed, rather than stalled, in the wake of the EU referendum result. The most obvious lens to see this dynamic through is employment growth. The six-month annualised growth rate of employment has fallen to 0.2%, the lowest in four years and a marked slowdown from the 1.5% seen on the eve of the vote (see Chart 4). However, while firms have been more cautious with regard to hiring, aggregate economic growth has held up better than anticipated. This growth has been accommodated by working existing employees harder. Indeed, while hiring has stalled, total hours worked have increased. Similarly, there have been signs that firms have finally managed to eke out some more productivity from their employees. Output per hour worked jumped to 1.2% y/y in Q4. Firms are making do with the labour force that they have right now. This looks like a sensible approach should activity soften as we anticipate in 2017. However, if growth continues to surprise to the upside they will probably need to start hiring again.

A hiring freeze?
Pay growth still subdued

Sustained weak productivity growth after the financial crisis has been an important force in suppressing wage growth. However, there have been few signs that the recent jump in productivity has triggered an improvement in pay (see Chart 5). Instead, aggregate wage growth has softened slightly over recent months. This deterioration looks even more unusual when we look at spare capacity. While employment has softened, the unemployment rate has continued to nudge lower, standing at a 12-year low of 4.7%. There are a couple of potential explanations for why wages have continued to disappoint. First, firms might be looking to offset some of the pressure they are seeing on margins by pushing down on other costs, including wages. The Bank of England (BoE) agents' report found that firms expected higher input costs following sterling depreciation to dampen pay settlements this year. Second, while spare capacity in the labour market has been falling, there might still be more left. This was the conclusion that the BoE came to in its February Inflation Report, as it revised its estimate of the equilibrium unemployment rate lower to 4.5% (previously 5.0%). Certainly there has been very limited pass through from a tightening labour market to wage pressures as yet. This could indicate more slack, or that the relationship between labour market slack and wages is very weak.

The direction of wages will be critical for how the Bank thinks about its policy settings in coming quarters. Soft wage and unit labour cost pressures at present will provide a degree of confidence that the current sterling-driven overshoot in inflation should prove to be temporary, helping to justify current supportive policy settings. Moreover, if wages do not accelerate then the squeeze on real incomes from higher inflation will continue and intensify over coming months, providing another reason for accommodation. However the BoE will need to be vigilant. If growth and the labour market prove more robust than we and the Bank forecast, then this would imply more inflationary pressures. Similarly, if it is wrong on the degree of slack, or tightness in the labour market starts to exert more pressure on wages, then it will need to reassess its policy settings. 

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Europe - Liberté for the labour market

The French Presidential election was arguably the most watched election of 2017, as markets fretted over the risk that the far-right Europhobic candidate Marine Le Pen would be the next French President, putting the future of the Eurozone in question. However, yesterday's election, in spite of low turnout and a record number of spoiled votes, saw centrist Emmanuel Macron secure the presidency with 66% of the total vote – beating polls that suggested an average 61% (see Chart 6). The President-elect ran on a campaign that emphasised the benefits of European cooperation and the need for reforms to the public sector and labour market. However, given that the Parliament –with which Macron must work to pass legislative reform – has still to be elected in June, and the fact that the French electorate is notoriously averse to change, Macron may be willing, but is he able?

Macron outperforms
Differing wage stories

One of Macron's toughest battles will be on the notoriously clunky French labour market. The President-elect wants to increase flexibility around working hours and pay; penalise short-term contracts –which accounted for 86% of total hires in 2016; and reduce social security contributions for low earners. Labour-market reform proved difficult to pass for the last French government and history may already be repeating itself: immediately after Macron's victory was announced, labour union protests were declared, reflecting the barriers that the new administration faces. However, if the new President and his cabinet can push ahead with their plans, this new-found flexibility should help to boost French competitiveness, which the World Economic Forum warned this year was being stymied by inefficiencies in the labour market, and reduce the still-elevated unemployment rate. That said, while Macron has pointed to the reduction in social security contributions increasing net income for workers, supply-side reforms to the labour market like Macron's proposed flexibility for firms can have a dampening effect on wage growth.

French wages were not exactly 'shooting the lights out' to begin with. Wages in France grew 1.5% in the year to Q4 2016, which is about average for the Eurozone, but modest nonetheless. Their German neighbours saw wages increase 2.9% over the same period, the strongest rate in the Eurozone. However, elsewhere in the Eurozone, wage growth is closer to non-existent (see Chart 7). In Italy, wages just turned positive in y/y terms in Q4, growing 0.1% after five straight negative quarters. In Spain, wage growth was positive but weak through 2016, coming in at 0.2% y/y in Q4. For these economies struggling with low wage growth, the increase in inflation in the Eurozone in recent months is likely to be putting a squeeze on real incomes unless wage growth has recovered strongly through Q1—we await wage data in the coming months to provide a firmer signal. However, it is hard to see what would drive such an improvement in wages; the ECB's latest bulletin highlighted that labour market slack remains considerable as reflected in measures of labour underutilisation. The risk of a real income squeeze is factored into our forecast, which assumes a rotation away from consumption-led to export-led growth. GDP growth in the Eurozone came in at 0.5% in Q1, which is encouraging and has led us to revise our 2017 forecast up a shade to 1.7%.

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Japan & Developed Asia - Waging war

With the dust having settled on the spring wage offensive, it is clear the results were unambiguously disappointing. Both the average wage increase and the basic wage portion of the wage hike stalled, rising 2.0% and 0.45% respectively. The outcome was dramatically out of sync with the incoming data on labour conditions, with unemployment in March touching a multi-decade low at 2.8% (see Chart 8). Other labour-market metrics such as the jobs to applicant ratio have also been pointing to ever tightening conditions. So why have workers’ unions come up empty handed? The result partly reflects the rigidities of the negotiation framework. Labour unions wage demands are determined by a convoluted formula based on inflation trends and corporate profitability in the prior 12 months, rather than the scarcity or otherwise of workers. However, the lack of pricing power for Japanese workers reflects more fundamental issue with the dynamism of the Japanese labour market. The base pay component in the Shunto wage can form the basis of wage-setting behaviour for a worker’s entire career. A commitment to raise the floor on current and future wage hikes is a powerful signal for future earnings potential, and also an important barometer of inflation expectations. However, it is also equally difficult to come by, as corporates are uniquely incapable of managing their full-time labour force over the business cycle. Efforts to rectify this issue have relied primarily on increasing the proportion of part time or temporary workers of a firm’s workforce. A more root and branch reform of full-time workforce practices has proven elusive, with proposals to change rules on monetary compensation for lay-offs and overtime pay repeatedly stalling.

No payback
Get real

Of course, the Shunto wage negotiations are simply a snapshot of one segment of the labour market. In reality, most workers are not members of unions and are largely employed by the nation’s SME firms. Is it possible that the cyclical improvements in the labour market are having a more material impact on earnings? The monthly Maikin labour survey provides clues as to where wage pressures are being felt most acutely. There are two key takeaways. First, the recovery in part-time wages has front-run the recovery in full-time wages, with the growth in part-time scheduled earnings almost double those for regular workers. Secondly, the recovery in nominal cash wages, which includes bonus and overtime pay, has led the recovery in basic wages. The good news is that both full-time and basic wage dynamics are now positive. However, the magnitude of improvement remains modest. The March data pointed to a shock decline in nominal cash wage growth, down 0.4% y/y, but smoothing this out, the rate of improvement over the last 12 months has been between 0.2-0.8% y/y - not inconsistent with the annualised growth indicated in the Shunto wage negotiations. More worryingly still, there are signs that the pronounced improvement in real incomes is starting to stall (see Chart 9). Having peaked in mid-2016, real income growth is once again stagnant as energy-related price pressures eat into the modest gains in nominal wages. Looking ahead, we suspect the balance between labour demand and supply to remain favourable for wages. However, the ability of the Bank of Japan to run the economy ‘hot’ enough to overcome the considerable hurdles constraining wage growth is questionable in the near term. Greater reformist zeal from the government may be required to unleash more powerful market forces on wage-setting behaviour.

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Emerging Markets - Stronger for now

Improving growth in China has had a positive impact on the labour market, bringing the 31-city unemployment survey down to its lowest point in three years (see Chart 10).  Although the unemployment surveys are among the most unreliable data series amongst China's statistics, a range of other data sets are pointing in the same direction. Real disposable income growth among both rural and urban workers also increased for the first time following three years of declining growth rates.  Other indicators also signalled a tighter job market - the job opening-to-job seeker ratio increased to its highest point in a decade. However, although most indicators point to improving labour dynamics, declines in median income growth suggest smaller income gains among the middle class.

Declining unemployment
Rising inequality

Digging deeper into employment statistics it's possible to get a sense of how the labour market is changing. Interestingly, both job seekers and job openings increased sharply over the last two quarters, breaking a multi-year trend of declines in both data series. It's unclear exactly why the amount of people seeking work increased as it did over the last two quarters. Despite a declining working age population, a rise in workers previously employed in sectors experiencing capacity reductions could have caused an increase in those looking for work. Looking at total number of employed person by industry it is clear that capacity reductions have had an impact on employment in metals and mining industries. Total employment in these industries has fallen significantly over the last two years, initially from falling prices and profits during the commodity prices collapse, but also from forced capacity reductions even as prices rebounded. From the same data series it is also possible to see where new labour demand is coming from, which highlights how China is rebalancing. Higher value added sectors and those associated with the environment are seeing rising demand for labour. For example, medical and pharmaceutical products, chemical fibres, and electronic and communication sectors have seen steady increases in overall employment figures. Sectors such as waste resources and processing, water production and gas production have also seen gains. This suggests that despite a stalling rebalancing process due to the recent stimulus, from an employment perspective, the losses stemming from fewer workers in heavy industry are at least partially being offset by gains in emerging industries.

Recent stimulus efforts and rapid growth in financial sector leverage may also be affecting the distribution of incomes bringing larger benefits to higher income earners. Although overall real income growth improved over the last quarter, real median income growth declined (see Chart 11). This breaks a multi-year trend of generally moving in the same direction. This suggests that those at the higher end of the income distribution saw larger gains. This could be an effect of rising leverage in the financial sector that brought gains to those working in capital markets; or perhaps due to the fact that stimulus over the past year largely improved the outlook for state-owned enterprises particularly around construction and infrastructure. It's unclear exactly what has changed that caused the median income growth rate to fall below the average, but Chinese labour data is rarely crystal clear. 

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