Employment lags activity, but leads the MPC - Capital Economics
UK Economics

Employment lags activity, but leads the MPC

UK Economics Update
Written by Ruth Gregory

While employment tends to lag changes in economic activity, the labour market figures will be crucial in leading the MPC’s decision about whether to cut interest rates or not in the coming months, even if there is a clear Conservative election victory and a Brexit deal by 31st January.

  • While employment tends to lag changes in economic activity, the labour market figures will be crucial in leading the MPC’s decision about whether to cut interest rates or not in the coming months, even if there is a clear Conservative election victory and a Brexit deal by 31st January.
  • The labour market, which was previously the stalwart of the economy, weakened in Q3. In fact, the 58,000 fall in employment was the sharpest drop since early 2015. But we doubt this tells us much that we didn’t already know. In the past, the labour market has tended to respond to changes in economic activity with a time lag (i.e. employment falls after the economy contracts) since employers cannot adjust the size of their workforces immediately. So the Brexit-related distortions which caused GDP to contract by 0.2% q/q in Q2 probably also explains the fall in employment in Q3.
  • This drop should be reversed soon. Based on the past relationship, we would expect Q3’s 0.3% q/q gain in GDP to prompt a 70,000 or so quarterly rise in employment in Q4. (See Chart 1.) In other words, just as Brexit has caused some temporary bumpiness in the GDP figures, it also appears to have caused some temporary volatility in the employment numbers.
  • Crucially, though, while employment lags activity, it is leading the Bank of England. Indeed, with the MPC unsure whether the recent weakening in GDP growth is mostly due to cyclical issues or structural factors related to Brexit that might not put downward pressure on inflation, the Committee is placing more emphasis on the labour market to judge this. With the unemployment rate in September of 3.8% still comfortably below the Bank’s estimate of the equilibrium rate of 4.25%, most MPC members have concluded that both potential and actual GDP growth have slowed. That suggests that there will be little downward pressure on inflation and no immediate need to cut interest rates.
  • However, a few MPC members think that there could be more spare capacity and weaker price pressures. After all, the two MPC members – Michael Saunders and Jonathan Haskel – who voted to cut rates in November did so as they thought the weakening in the labour market was generating more spare capacity.
  • And since the Committee last met, other labour market indicators will have reinforced those concerns. The stock of unfilled job vacancies has fallen, firms are finding it easier to find workers to fill new posts and employment intentions have tailed off. (See Chart 2.) What’s more, the drop in pay growth, from almost 4% in mid-2019 to 3.6% in September, supports the idea that there may now be more spare capacity in the labour market.
  • Clearly much will depend on what happens next. If the election result is inconclusive and there are more Brexit delays, then sluggish GDP growth would probably mean that the labour market weakens further and the Bank of England cuts rates. (See Chart 1.) But if there is a decisive election result that means there is no further weakening in the labour market, which we think is more likely, then rates will probably stay on hold. Either way, the labour market data released in the coming months will have a bigger bearing on the rate outlook than usual.

Chart 1: Real GDP & Employment

Chart 2: Measures of Labour Market Tightness/Slack

Sources: Refinitiv, ONS, Capital Economics

Sources: Refinitiv, Capital Economics


Ruth Gregory, Senior UK Economist, +44 20 7811 3913, ruth.gregory@capitaleconomics.com