EY ITEM Club warns that rate hike must be tied to real wage growth as unemployment target set to be reached this year

20 January 2014

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LONDON, MONDAY 20 JANUARY 2014: A rapidly improving labour market will see the UK hit the Monetary Policy Committee’s unemployment threshold two years earlier than expected, says the latest quarterly forecast from the EY ITEM Club.  However raising interest rates too soon, before real wages have also begun to improve, could risk choking off the fragile consumer led recovery, warns the report.

The EY ITEM Club’s Winter forecast says that unemployment will fall below 7% in the first half of the year, driven by an improving economic outlook and a surge in demand for labour. However, unlike a normal recovery, EY ITEM Club says that the swelling workforce is likely to suffer weak growth in earnings, with wages set to grow by only 1.8% this year, before slowly picking up to 2.7% in 2015 and 3.5% in 2016. 

The report is calling for the MPC to urgently supplement the forward guidance threshold to include positive growth in real wages alongside a lower threshold for unemployment.

Citing a “lop sided recovery” the forecast also warns that a more balanced economic recovery through business investment and exports will be crucial before a rate rise is considered. The EY ITEM Club forecasts the first interest rate hike in the autumn of 2015 when conditions for a broader recovery should be satisfied.

Consumer recovery continues with GDP growth of 2.7% in 2014

The forecast predicts that, despite depressed wages, consumers will remain the driving force behind the economic recovery in the short term, which will see UK GDP growth of 2.7% in 2014, up from 1.9% in 2013 – driven by a fall in inflation, a strengthening housing market and further strong employment growth. However the transition to a more balanced economic growth over the medium term is unlikely to be smooth, with the report predicting GDP growth of 2.6% in 2015, before cooling to 2.5% a year from 2016-17.

Peter Spencer, chief economic advisor to the EY ITEM Club comments: “It is hard to find another episode in time where employment has been rising and real wages falling for any significant period of time. The weakness of real earnings is proving to be the Government’s Achilles heel and could prove to be the weak spot in the recovery.

“Consumers have reduced the amount they save to fund their spending sprees. But they cannot continue to drive growth for much longer without an accompanying recovery in real wages or a rise in their debt to income ratio.”

 Immigrants, pensioners and benefit cuts will transform the labour force by 2015

The labour force is also expected to continue to grow. The report predicts that older workers delaying retirement, immigrants, and the impact of government cuts will add another million to the labour supply over the next two years, continuing the transformation of the labour market. The report says that in the next two years 400,000 older workers, who would previously have retired will hold on to their jobs – far outstripping the number of new immigrants or former public sector workers joining the private sector workforce.
 Mark Gregory, EY’s chief economist, says that the strong demand for labour will create a competition for talent, while all sectors must face up to a changing workforce.

 “The challenges on the labour front will become a real pressure point for business, with a war for talent in high growth areas such as the construction, professional, technical and scientific services.  At the same time, a changing demographic and later retirement will represent an unforeseen challenge for managing human capital.”

 No bubble in housing

The housing market will continue to support the consumer recovery, rather than entering bubble territory, the report adds. The market is set to accelerate further – driven by the Help to Buy scheme as well as higher employment levels. However stronger supply will act as a brake on house price growth. The report cites a 41% increase in new construction orders, taking supply to levels close to pre-crisis levels, helping to contain price rises. The forecast expects house prices to rise by 8.4% in 2014 and 7.3% in 2015, keeping the price-to-income ratio below recent peaks.
 Spencer continues: “There is little evidence of a housing bubble at present; prices are still well shy of their pre-crisis peaks in money terms and some 25% lower in real terms, while affordability and indebtedness measures are far less stressed than they were during the financial crisis. The stronger market has encouraged a robust pickup in house building and our forecast shows this continuing, with residential investment recovering strongly.”

Broader economic recovery: business investment and exports slowly pick up by 2015

 The report highlights that despite being largely absent in the recovery so far, business investment will finally make a comeback, boosted by growing corporate confidence. Business investment will increase by 5% this year, before rising by 9.3% in 2015. However the report warns that the figures remain modest by historical standards and says it may take another four years before it returns to its pre-crisis peaks.
Similarly, exports are also set to rise. With world trade continuing to accelerate, the report forecasts UK exports will grow by 3.3% in 2014 and 5.2% in 2015 after just 0.8% in 2013.
Mark Gregory comments that the nature of the recovery will force inactive businesses to finally take action.
“Following a long period of hibernation, where risk-averse managers focused on preserving cash, business confidence is now slowly returning. Now is the time for businesses to look at putting their investment plans into action.

“The winners will be those who get the timing right. With growing confidence, high cash balances and increased availability of finance, businesses that wait too long will run out of road and find themselves acquisition targets.”

Positive surprises will come from companies, not consumers

Spencer concludes: “In the short term, the recovery continues to be driven by consumer spending and housing. The next two years will see businesses start to do their share of the heavy lifting to ensure a more balanced recovery. For positive surprises we need to look to companies, not consumers as business investment and exports finally make an impact.”