A temperature check for the UK labour market

Those economists who have been proved right to be pessimistic about prospects for UK economic growth following the recession of 2008-09 have nonetheless been surprised by what’s happened to the labour market. For example, the unemployment rate, which had been widely forecast to reach 8.7% by the end of 2012, will probably end the year at below 8%. It would be wrong, however, to conclude that this means the labour market has got off relatively lightly in the period since the financial crisis first broke. On the contrary, the degree of pain inflicted on the labour market has been as severe as expected it’s just that the pain has been felt in a different way. In particular, an unprecedented post-war slump in real earnings – caused by a mix of below inflation pay rises and shorter hours working - has served to spread pain throughout the workforce rather than, as in previous recessions, seen it concentrated on the unemployed.

Consequently, while unemployment remains the key central indicator of the overall balance of supply and demand in the labour market it doesn’t provide a full temperature reading. My consultancy The Jobs Economist (www.thejobseconomist.org) is therefore publishing a Labour Market Temperature Index (LMTI), a variant on the well-known Economic Misery Index first devised by economist Arthur Okun in the 1960s. The original Misery Index was calculated by adding the unemployment rate to the consumer price inflation rate. The labour market variant instead adds the unemployment rate to the rate of change of real earnings.

The LMTI takes into account the impact of (CPI) price inflation, nominal pay increases and changes in average hours worked per person, the latter two variables determining the rate of growth of average weekly earnings. The index is in turn benchmarked against an even temperature reading for the labour market, set at zero. A sub-zero reading is a measure of deficient demand for labour assuming that the chosen even temperature benchmark reflects the sustainable (or structural) rate of unemployment and the sustainable rate of average real weekly wage growth. Sustainable in this context means the rates consistent with the official policy target of 2% CPI inflation, which on the basis of estimates currently implicit in economic modelling by the independent Office for Budget Responsibility (OBR) corresponds to an assumed sustainable rate of unemployment of around 5% and sustainable real average weekly wage growth of around 2%.

The LMTI should be considered a temperature index rather than a misery index since its purpose is to gauge fluctuation in the demand side strength or weakness of the labour market rather than measure the precise extent of human distress or misery this causes. Although any sub-zero LMTI reading will increase misery, the same overall temperature reading can give rise to a variety of configurations between pay, hours of work and unemployment, with those resulting in higher unemployment generally thought to be the source of greater misery. The post 2008 configuration is therefore likely to have been associated with less misery than the higher unemployment configurations witnessed in the wake of the 1980s and 1990s recessions.

The figure below shows how the UK’s LMTI has fluctuated since 2000. Prior to the recession of 2008-9 the overall temperature reading was close to or above zero. Unemployment at that time was likely to have been close to its underlying structural rate, with the strength of demand for labour resulting in higher real wage growth for people in work. Since then mounting labour market weakness has shown up in a combination of higher unemployment, shorter working hours and real wage reductions. Comparing 2008 and 2012 the net reduction in demand for labour as measured by the fall in the LMTI is more than twice that indicated by the rise in unemployment. The cooling shown by the LMTI is thus more indicative of the overall degree of pain inflicted on the labour market since the start of the financial crisis.       

The labour market was at its coldest in February 2009 with a LMTI reading of -13. Things warmed up a little in early 2010 but cooled again in 2011. Though the labour market temperature has improved in 2012 in response to a fall in unemployment and moderation in the squeeze on real earnings, sub-zero conditions continue. Indeed, a projection of the LMTI based on the latest OBR economic forecast, published last week alongside the Chancellor’s Autumn Statement, suggests a further period of cooling in the near term with subsequent warming to 2018 doing no more than easing the chill.  If the OBR forecast proves correct the UK labour market will eventually have suffered a sub-zero decade, still be feeling cold, and some distance from returning to the pre-financial crisis climate.