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How the hot UK labour market is driving interest rate forecasts

Financial markets expect the Bank of England to increase interest rates as early as next spring as evidence grows that a hot UK labour market is spurring wage and price inflation.

Before the central bank’s hawkish shift at its meeting last week, traders had expected the first rise in interest rates from the historic low of 0.1 per cent to 0.25 per cent at the end of 2022. But in the week since its meeting, they have priced in a change between the February and May meetings next year.

The bank’s Monetary Policy Committee put the labour market at the heart of its judgments and, unlike many economists, now thinks the unemployment rate has peaked.

Christian Schulz, lead UK economist at investment bank Citi, said: “If the bank is right and unemployment has already peaked, it will hike [interest rates] in February.”

Data published since the BoE’s meeting has done nothing to suggest the labour market is cooling even as the Delta coronavirus variant spread across the UK in July.

In their monthly report on labour market trends, advisory firm KPMG and the Recruitment & Employment Confederation found that job placements barely dipped from the record levels in June and took off in previously weaker parts of the country, especially in London, where Covid-19 had hit employment the hardest.

With staff availability low and companies in all sectors facing severe recruitment difficulties, the KPMG/REC survey found the number of employers saying they had increased pay rose in July to its fourth consecutive record.

Line chart of UK permanent placements index (above 50 = higher than previous month) showing London is leading the way in jobs growth

Kate Shoesmith, REC deputy chief executive, said it was “a good time to be looking for a new job” and recruiters were struggling to fulfil employers’ requirements.

However, the BoE is worried that higher pay will result in companies having to raise prices, casting doubt on its central prediction that inflation will moderate in 2022 after peaking close to 4 per cent later this year.

The MPC said last week it would be “monitoring closely the incoming evidence regarding developments in the labour market, and particularly unemployment, wider measures of slack [in the economy] and underlying wage pressure”.

The committee was willing to ignore what it thought were temporary “frictions” arising because some sectors had opened up suddenly with many companies all looking for staff simultaneously. But it added it would be concerned about wider evidence of staff shortages leading to wage inflation.

At the August meeting, the BoE’s regional agents pointed to “shortages of heavy goods vehicle delivery drivers” and a wider dearth in people looking for work, but other data released after the meeting showed the surge in vacancies runs significantly more broadly than logistics.

Data on job advertisements from Adzuna, the recruitment website, published by the Office for National Statistics showed that the volume of online job adverts was running above the 2019 level in every sector.

Job adverts remain significantly higher than pre-pandemic levels Number of online job adverts by category (100 = Feb 2020 average) G1336_21X

Tony Wilson, director of the Institute for Employment Studies, said the latest evidence from the labour market suggested that unemployment was likely to fall from the 4.8 per cent rate recorded by the ONS in the March to May quarter.

“The big challenges given high demand will be bringing more people back into the labour market, helping the long term unemployed [find jobs] and also helping those losing or changing their jobs to get new ones quick,” he said.

This view depends, however, on Covid remaining under control in the autumn, allowing the economy to continue its sharp recovery. If cases and hospitalisations rise, the economic growth rate would slow, said Samuel Tombs, UK economist at consultancy Pantheon Macroeconomics, and if the pandemic intensified with force over the autumn, the BoE might even have to ease policy again.

“In contrast to last winter, the MPC likely would ease policy first of all by reducing Bank Rate, instead of by extending quantitative easing,” said Tombs.

One of the traditional escape valves for the UK economy during labour shortages has been migration, particularly under the EU’s freedom of movement rules.

It is, however, difficult to know whether a lack of migrants is compounding labour shortages, according to Madeleine Sumption, director of the Migration Observatory at Oxford university. Covid has undermined the reliability of migration statistics, she said.

While it was probable that there had not been a sudden exodus of foreigners during the pandemic, Sumption said the evidence suggested “it is certainly the case in 2020 that something pretty extreme happened to [inward] migration and there was a lot less of it . . . It is a big break from previous patterns”.

In the Treasury, officials are quick to dismiss suggestions that Brexit and a lack of migrant workers is causing the labour shortages except perhaps in London, but chancellor Rishi Sunak is concerned about the consequences. He has told friends that rising inflation and, perhaps, interest rates, are among his greatest concerns, adding to pressures on the public finances from higher costs of servicing government debt.

The BoE’s hope is that the end of the furlough scheme next month takes some of the heat out of the labour market this autumn. As the government winds back support, companies will have to take back hundreds of thousands of previously employed workers or make them redundant.

The MPC’s assumption that the end of the job support initiatives will encourage many more people to seek work and reduce the pressures on wages and prices is underpinning its guidance that only “modest” rises in interest rates will be needed over the next three years.

It thinks that beneath the hot surface, there is “a material amount of labour market slack”, but will want to see more evidence of a cooling after the summer to allow it to remain relaxed about inflation through the rest of 2021.

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