Mr King explores lessons from the UK labour market
Text of the Employment Policy Institute's Fourth Annual Lecture delivered by the Deputy
Governor of the Bank of England, Mr Mervyn King, held in London on 1/12/98.
It is both an honour and a challenge to deliver the fourth EPI lecture. It is an honour to follow in
such distinguished footsteps, and it is a challenge to tackle the subject of the link between
monetary policy and the labour market. Few subjects are as emotive. Wages, jobs and
unemployment feature as frequently in the popular press as they do in academic articles. The
Bank of England must learn from one in order to convey our message in the other. And we are
fortunate in that labour economics is a field in which British economists have been - and
continue to be - at the forefront of research. That I can say objectively because I am not myself a
labour economist. So tonight I shall be exploring lessons from the labour market for the
Monetary Policy Committee. The Employment Policy Institute has played an important role in
bringing together those undertaking research on labour markets and those involved with policy
decisions. In particular, its Employment Audit provides a valuable commentary on current
developments.
The labour market is unlike any other market. Indeed, for many people the very language of
economists - equilibrium unemployment, market-clearing wages - seems incompatible with the
human dimension of unemployment and deprivation. Are the 16 million unemployed people in
the European Union merely an equilibrium, on the one hand, and a statistic, on the other? But for
most people the labour market is the market where - for better or worse, in sickness or in health
- they sell their time and their skills at a market price. That price determines, in large part, their
opportunities and economic welfare. Wage rates have a much greater significance in influencing
the distribution of real incomes than do the prices of almost anything else. As a result, the labour
market cannot be divorced from broader social and political considerations.
If their terminology and language are sometimes insensitive, what do economists have to offer by
way of ideas about unemployment? The prize for the most important idea and most insensitive
terminology surely goes to Milton Friedman for the concept of the natural rate of unemployment.
I shall discuss shortly the significance of this idea for monetary policy. But for a more elegant
advocacy of a similar position it is necessary to delve further back in history.
This month sees the 75th anniversary of the publication of what Milton Friedman described as
John Maynard Keynes' best book: A Tract on Monetary Reform. It is undoubtedly one of the
most persuasive polemics ever written on the subject of monetary policy. To coincide with
publication in December 1923, Keynes gave a lecture to the National Liberal Club in which he
talked about "the triple evils of modern society". From the notes he used for that lecture - printed
in his Collected Writings - we can see that Keynes regarded the evils as, first, the "vast
enrichment of individuals out of proportion to any services rendered"; second, the
"disappointment of expectations and difficulty of laying plans ahead"; and, third,
"unemployment". Fat cats, short-termism and the jobless society: Keynes was ahead of his time.
All these, Keynes argued, were "mainly due to instability of the standard of value". Over the past
20 years, Britain faced the same three problems. The income distribution widened and the
rewards for those with special talents, and even for some with no apparent talent, increased
significantly more than earnings for the unskilled. Both inflation and expectations of inflation
were high and unstable, making it more difficult for firms to plan for the long term. And the
unemployment rate rose to double-digit levels.
Keynes argued that the way to prevent those triple evils from undermining society was price
stability. Central bankers should be as vigilant in countering deflation as in preventing inflation.
The link between unemployment and inflation has been a central theme in macroeconomics for
the remainder of the century.
Following the publication of A Tract on Monetary Reform, Keynes received a letter from none
other than the Deputy Governor of the Bank of England. "Dear Keynes," he wrote, "I write to
you in this familiar fashion because we are both old Kings' Scholars, though not of the same
election." So far, so good. Regrettably, however, the then Deputy Governor's only comment on
the book appeared to be that he was grateful to Keynes for writing in a style which an educated
man could read with pleasure, and for having the book printed in a particularly attractive style.
This Deputy Governor has learned a great deal from Keynes' book. I refer to it in almost every
lecture I give. In this lecture I shall discuss three aspects of the significance of the labour market
for monetary policy. The first of these concerns the link between unemployment and inflation in
the transmission mechanism of monetary policy.
The second issue is how the Monetary Policy Committee uses the available empirical
information about the UK labour market when deciding on interest rates. How do unemployment
figures and earnings data enter the MPC's decisions?
The third issue is the way in which unemployment enters the objectives of monetary policy. With
an explicit inflation target, is it true that the MPC neither cares about unemployment nor takes it
into consideration when setting interest rates?
The labour market and the monetary transmission mechanism
The theory of unemployment has spawned more concepts, and - without doubt - more acronyms,
than almost any other field of economics (apart, perhaps, from measures of price inflation). I
shall return to the language of unemployment later. But I want first to discuss the two concepts
which are at the heart of any discussion of monetary policy and the labour market. They are the
natural rate of unemployment and the rate of unemployment consistent with stable inflation,
usually known as the NAIRU.
The concept of the natural rate of unemployment introduced by Milton Friedman and Edmund
Phelps 30 years ago is the level of unemployment that - as Friedman famously described -
would be "ground out by the Walrasian system of general equilibrium equations" reflecting the
structural characteristics of the labour and product markets. Friedman was the first to recognise
that this natural rate of unemployment was neither constant over time nor immune to policy
influences.
The natural rate hypothesis implies a vertical long-run Phillips curve. In other words, if the
monetary authorities attempted to "peg" the level of unemployment below the natural rate, then
this in time would cause the inflation rate to rise indefinitely. The work of Friedman and Phelps
soon proved highly relevant. The futility of using monetary policy to choose between different
combinations of unemployment and inflation became only too apparent in the 1970s. Monetary
shocks can - and in the early 1980s and 1990s did - cause unemployment to deviate from its
natural rate, but only for a period. As inflation expectations catch up with the consequences of
the monetary shock, unemployment returns to the natural rate.
But the responses of unemployment and inflation expectations to monetary shocks are far from
immediate. Indeed, Friedman speculated that the full adjustment to an unexpected change in
inflation might take up to "a couple of decades". Such long lags in the dynamics of the labour
market mean that there is unlikely to be a simple relationship between deviations of
unemployment from its natural rate and changes in the inflation rate. Chart 1 shows that it did
indeed take almost 20 years to bring inflation and inflation expectations (implied by financial
market returns on indexed and conventional gilts) down from double-digit levels to the current
target of 22%, accompanied by a large rise and subsequent fall in unemployment.
The idea of the NAIRU can be thought of as a conceptual response to inertia in the system which
means that the response of the economy to shocks will be protracted. In 1975 Franco Modigliani
and Lucas Papademos introduced the concept of the non-inflation rate of unemployment - the
NIRU - defined as "a rate such that, as long as unemployment is above it, inflation can be
expected to decline". Note in passing that more appropriate terminology would be the
nonincreasing inflation rate of unemployment (NIIRU). Modigliani and Papademos recognised that
the NIRU would be affected by macroeconomic shocks. They argued that there was evidence to
suggest that "over the last two decades the NIRU [in the US] was held down by a favourable
trend in the terms of trade between the private nonfarm sectors on the one hand and imported
goods and farm products on the other. A termination or reversal of this trend would tend to raise
the NIRU, at least temporarily."
It is ironic that two of the most prominent economists of countries synonymous with art and
beauty - Italy and Greece - (one a future Nobel prize winner and the other a future central bank
governor) should have given birth to an unattractive acronym that has spawned so many even
more unappealing cousins. The first, and most feted, offspring - the NAIRU - was introduced by
James Tobin five years later. NIRU, NIIRU, NAIRU - tongue twisters for the Financial Times
Christmas quiz, or measures of the Inflationary Trigger Point? Take your choice. For the sake of
simplicity I shall adopt the conventional term, NAIRU, to represent the entire family.
So what is the relationship between the natural rate of unemployment and the NAIRU? The
natural rate of unemployment and the NAIRU are quite different concepts. The former describes
a real equilibrium determined by the structural characteristics of the labour and product markets
- the grinding out of Friedman's Walrasian general equilibrium system (modified, if necessary,
by non-Walrasian features of labour markets such as imperfect competition, search behaviour
and efficiency wages). It exists independently of the inflation rate. In contrast, the latter, as well
as being affected by these structural characteristics, is also affected by the gradual adjustment of
the economy to past economic shocks that determine the path of inflation. Because it is defined
as the unemployment rate at which there is no immediate pressure for a change in the inflation
rate, it is a reduced form - not a structural - variable.
This difference is reflected in the methods used to generate empirical estimates of the two
concepts. The natural rate of unemployment can be estimated only by reference to a structural
model of the labour market which has explicit microeconomic underpinnings and which can be
used to identify the characteristics determining the natural rate. Empirical estimates of the natural
rate would typically be related to inflation only in the long run when the effects of shocks
average out. In contrast, the NAIRU is estimated using a system of time-series equations relating
inflation to past and present economic shocks. The sole criterion for judging the success of
estimates of the NAIRU is their short-term correlation with inflation. Indeed, the NAIRU as
defined here - and in recent work by Estrella and Mishkin (1998) - is the level of unemployment
such that the difference between it and the current rate of unemployment is all that is necessary to
describe short-run inflationary pressure.
Although the NAIRU will tend towards the natural rate of unemployment in the long run, there is
no reason to expect there to be a close relationship between the two measures in the short run.
The natural rate is likely to move only relatively slowly over time in response to changes in its
structural determinants. In contrast, the NAIRU will vary both with changes in the natural rate
and in response to macroeconomic shocks. So those who argue that estimates of the NAIRU are
too time-varying to be plausible are, I think, in danger of missing the point.
The NAIRU can be used as an ex-post device to describe the level of unemployment at which
inflation started (or would have started) to increase. But the usefulness of these estimates as an
ex-ante predictor of future inflationary pressure depends critically upon the economic
environment. In particular, for estimates of the NAIRU to be a good predictor of future inflation,
the natural rate would need to be relatively stable, and the magnitude of likely shocks would need
to be small. This perhaps goes some way to explaining why estimates of the NAIRU in the recent
past have appeared to contain more ex-ante information about future inflation in the US than they
have in Europe.
More fundamentally, the distinction between the natural rate and the NAIRU illustrates the
difficulty of using those concepts for the month-to-month implementation of monetary policy.
The natural rate, although clearly relevant to the dynamics of inflation, is not sufficient to explain
changes in the inflation rate. The NAIRU, which is defined to be a measure related to short-run
inflationary pressures, requires knowledge of the reduced form of the transmission mechanism
and the history of shocks to the economy. But that knowledge is required also for a forecast for
inflation, and so the NAIRU itself provides no additional information over that contained in the
forecast. Indeed, estimates of the NAIRU could be described as a by-product of the process of
forecasting inflation.
As an example, consider the impact of the appreciation of sterling from mid-1996 until late 1997.
Retail price inflation can be thought of as a weighted average of domestic and imported inflation.
The substantial real appreciation of sterling since mid-1996 has for a while reduced the imported
component of UK inflation and so, in turn, retail price inflation, below the level that it would
otherwise have reached. In essence the NAIRU fell relative to the natural rate. That restraining
effect on inflation will gradually wear off and begin to be reversed if sterling continues to fall.
The issue of whether the domestic inflation component would fall to a level consistent with the
inflation target by the time this temporarily depressing effect wore off was central to the
monetary policy debate during the summer.
The example of sterling's appreciation shows how a macroeconomic shock, entirely independent
of the labour market, can affect the relationship between the rate of unemployment and the rate
of inflation. The rise in sterling is likely to have reduced the NAIRU via two separate channels.
First, in the short run, the relationship between domestically generated inflation - of which wage
inflation is a substantial element - and retail price inflation shifts because of lower imported
inflation. Second, the temporary improvement in the terms of trade that followed the rise in
sterling in 1996 reduced the wedge between the real consumption wage - which is of relevance
to employees and which reflects a mix of both domestic and imported inflation components -
and the real product wage - which is of relevance to employers and which reflects the prices only
of domestically produced goods. That reduction in the wedge is likely to have reduced the
pressure on nominal wage growth for any given level of unemployment.
So it is quite possible to believe that the NAIRU has fallen even if the natural rate has not. But
this is likely to be temporary. As the impact of sterling's appreciation on wages and prices wears
off, the NAIRU will, other things being equal, rise towards the natural rate. But other more
lasting changes may reduce the natural rate (and hence the NAIRU). For example, a range of
government policies, including changes to the Jobseekers Allowance, the New Deal and the new
Working Families Tax Credit, have increased incentives to work. The National Minimum Wage
works in the opposite direction. Assessing the impact of these structural factors on the natural
rate is no easier than calculating the effect of macroeconomic shocks on the NAIRU. But it is
useful to distinguish the two concepts, not least because they can move quite differently in the
short run.
Enough of this theory, some of which may appear largely semantic. None of it is, of course,
either new or original. But understanding the language of unemployment matters. Richard
Rogerson, in the Journal of Economic Perspectives last year, posed the question: "Have the
language and concepts developed by economists in their study of unemployment served their role
of fostering clear communication of findings and allowing issues to be sharply defined?"
Professor Rogerson's conclusion, you will perhaps not be surprised to hear, was a resounding no.
Neither the natural rate nor the NAIRU are terms well chosen to win friends and influence
people. After all, there is nothing natural about the natural rate.
Whatever we call them, it is crucial to recognise that there is considerable uncertainty about the
location of both the natural rate of unemployment and the NAIRU. Even in the United States,
where there appears to be no obvious trend in the natural rate, estimates of the 95% confidence
interval for the NAIRU are typically from 5% to 7.5%. In the UK where both structural reforms
and macroeconomic shocks have had a larger impact than in the US, the range of uncertainty is
even greater. Perhaps the most honest answer to the question of what is the natural rate was that
given by Milton Friedman to the Wall Street Journal in January 1995: "I don't know what the
natural rate is, neither do you, and neither does anyone else."
The labour market and monetary policy in practice?
How do these concepts affect monetary policy in practice? And what role does analysis of the
labour market play in the Monetary Policy Committee's decisions on interest rates?
Using the language of unemployment developed earlier, the MPC has to assess whether the
current level of unemployment differs significantly from the NAIRU and, as importantly,
whether it is likely to remain so in the future. It may do that explicitly by taking a view on the
level of the NAIRU, or it may do it implicitly by producing a forecast for inflation. In practice,
we focus directly on an inflation forecast.
But the need for policymakers to focus on the level of unemployment and the level of output
each time they assess the stance of monetary policy is unavoidable. Alan Greenspan has to do it.
MPC members have to do it. Knowing that the growth rate of GDP is (or is likely to be) above or
below its trend rate of increase is of little value unless one also knows where the level of output
is relative to potential. This is a basic, but fundamental, point. If, for whatever reason, the level
of unemployment is below the natural rate, a rise in unemployment is unavoidable. That may be
undesirable. But any attempt to avoid it will simply result in a longer, or more pronounced,
correction at a future date. In order to hit the inflation target the MPC needs to minimise
deviations in the level of output from potential, not in the growth rate of output from its trend.
The need to focus attention on the level of economic activity is of course well understood by the
academic community. It is now standard practice in the literature on monetary policy to assume
that the authorities seek to minimise a social loss function, defined in terms of the deviation of
the level of output or unemployment from their equilibrium values, and in terms of the deviation
of inflation from its desired value. But if this is so obvious, why, in discussions of the economic
conjuncture and economic policy, is so much attention placed on growth rates rather than on
levels? Why are commentators and pundits so concerned with whether economic growth is going
to be above or below its trend rate, or even whether it is likely to be above or below zero? That is
not what matters for economic policy nor, more importantly, for social welfare.
An excessive focus on growth rates of output and employment, rather than on their levels, may
reflect a rather natural, but dangerous, optimism about the degree of spare capacity in the
economy. After all, is not the belief that we could always achieve lower unemployment without
an increase in inflation the mark of a kinder, gentler, altogether more civilised approach to
economic policy? Or is it simply wishful thinking? As Greg Mankiw put it:
"Wishful thinking is one reason that monetary policy has historically been excessively
inflationary... To my mind, wishful thinking is as worrisome a problem for monetary policy as
time inconsistency."
Genuine concern for the unemployed means a recognition that sustainable reductions in
unemployment require a combination of monetary stability on the demand side and
microeconomic reforms such as the New Deal on the supply side. As Alan Blinder has reminded
us, we need soft hearts and hard heads, not the other way round.
Despite suggestions to the contrary, the MPC does have soft hearts and hard heads, and does not
base its assessment of the labour market - never mind its decisions on interest rates - solely on
estimates of the growth of average earnings. An assessment of the overall tightness of the labour
market requires all the available data - both quantity and prices - to be analysed. The wealth and
diversity of published labour statistics means it is rare for them all to point in the same direction.
The MPC's analysis of the labour market is like the construction of a jigsaw puzzle. The pieces
of data are assessed alongside each other in order to build up as clear a picture as possible. No
single piece of data is interpreted in isolation. And no single piece of data is, in itself, decisive.
The growth of wages and salaries is an important indicator of domestically generated inflation.
But this does not imply that there is some magical threshold defining "acceptable" and
"unacceptable" rates of earnings growth. In the short run, the link between earnings growth and
inflation is complicated by a whole host of factors, including exchange rate movements, cyclical
variations in productivity and profit margins, irregular bonus payments, and one-off adjustments
to tax rates and other "wedge" effects. It is true that given the UK's historical levels of annual
productivity growth of around 2% and the inflation target of 22%, it would be a cause for
concern to the MPC if average earnings increased by much more - or much less - than 4.5% a
year over a prolonged period without there being a corresponding change in trend productivity
growth. That is not because the Committee has a view about the appropriate level of pay awards.
It is not our job to second-guess what businesses should or should not pay their employees. Nor
is it because we think earnings growth causes inflation - inflation is a monetary phenomenon.
Rather it is because sustained earnings growth much above or below these rates may indicate that
the level of utilisation in the labour market has reached a level inconsistent with the inflation
target.
The June meeting of the MPC drew particular attention to the rise in headline earnings growth as
measured by the Average Earnings Index. But that should be viewed against a background of
increasing concern about the tightness of the labour market. In its meeting in April, the Monetary
Policy Committee noted that "labour market data on quantities were signalling a tighter position
than the price [earnings] data". At that time, the Labour Force Survey and claimant count
measures of unemployment had both fallen below their previous troughs recorded in the spring
of 1990, and were still declining. This position was evident across all categories of
unemployment, as can be seen from chart 2 which shows the various measures of joblessness
reported in the EPI's Employment Audit. In addition, employment and total hours worked were
rising quite strongly; recruitment intentions were at their highest level for nine years, with the
level of vacancies at Jobcentres, and the average duration of these vacancies, both well above
their 1988/89 peaks; and survey measures of recruitment difficulties were also at high levels.
The underlying rise of the Average Earnings Index had increased to 42% by the beginning of
1997, but was little changed by the end of the year. If I had been asked to deliver the third
Annual EPI lecture, rather than the fourth, the main question you might have expected me to
grapple with would have been why earnings growth had not at that point risen by more, given the
1.0 million fall in unemployment and the 1.4 million rise in LFS employment since the end of
1992. As a Committee, we discussed at some length during the spring of this year why the
changes in the quantity measures had not fed through to higher earnings growth. We discussed
whether the natural rate of unemployment (and the NAIRU) might have declined due to an
increase in trend productivity or improvement in the functioning of the labour market. We also
considered whether there had been independent influences on the NAIRU stemming from falls in
inflation expectations or the effects of sterling's appreciation.
It is against this background that the MPC's decision to raise rates in June should be seen. The
increase in headline earnings growth to 4.9% in February, from an upwardly revised 4.6% the
previous month, appeared consistent with other labour market indicators. But we were fully
aware of the evidence suggesting that the rise in earnings growth had been, and for a couple of
months would continue to be, affected by unusually large bonus payments. If this was true,
earnings growth might well have fallen back once the bonus effect had dropped out. Given the
uncertainties in this area, the Committee concluded that it should not place too much weight on
the latest numbers. Instead, it stepped back and examined the underlying trend in the labour
market over the previous two years. We noted that private sector earnings growth had been rising
throughout this period and that reported wage settlements displayed a similar profile. Given this
longer-term perspective, the Monetary Policy Committee concluded that capacity constraints in
the labour market were threatening the attainment of the Government's inflation target.
Of course, since then, the earnings data have been successively revised, rebased and suspended -
a piece of the jigsaw has temporarily gone missing. As you can see from chart 3, the profile of
the old series showed a steady rise in earnings growth from around 33% in mid-1995 to nearly
52% or so by the spring of this year. In sharp contrast, the revised and rebased data (before they
were suspended) followed roughly the shape of a slightly squashed capital N. From a trough of
3% at the end of 1995, earnings growth was estimated to have risen to a peak of over 53% in
February and March 1997 before falling back below 4% in early 1998 and then bouncing back
above 5% again by May.
How would the MPC's analysis of the labour market have changed if the revised (but now
suspended) data had been available six months earlier? That question is not easy to answer. The
quantity data would still have suggested that the labour market was both tightening and, by
historical standards, tight. The MPC would therefore have had the unenviable task of trying to
understand why the steady tightening in the quantity measures had produced a zigzag path for
measured earnings growth. We would also have had to try to understand why the zigzag profile
of the new Average Earnings Index was not visible in other measures - shown in chart 4 - of
nominal earnings growth, such as wage settlements and private surveys. As I have said
elsewhere, trying to reconcile the new earnings series with other labour market data is far from
easy.
The Chancellor wrote to Giles Radice, the Chairman of the Treasury Select Committee, on 23
October announcing that he had asked Sir Andrew Turnbull and myself to conduct a review of
the revisions to the average earnings figures. The review, which is considering both
methodological and managerial issues, is being carried out by Martin Weale of the National
Institute, supported by Peter Sedgwick of the Treasury. Martin and Peter have made an enormous
effort over the last month or so to finish the review as quickly as possible. However, exactly
when the Report will be finished and what it will conclude are, I am afraid, still not known. As a
result, the ONS has yet to decide when to resume publication of the average earnings series. All I
can say today is watch this space.
The labour market and the objectives of monetary policy
In the final part of my talk, I want to turn to the question of what this analysis of the labour
market implies for monetary policy. One of the - perhaps the - most important economic and
social problems facing Europe is the high level of unemployment: 16 million unemployed people
throughout the European Union, a rate of over 10%, with young people under 25 accounting for
almost a quarter of this total. That represents a major failure of economic policy. But is it a
failure of monetary policy? To go one step further, should the objectives of monetary policy -
whether enshrined in the Maastricht Treaty or in the Chancellor's remit for the Monetary Policy
Committee - be altered to include an explicit reference to unemployment? Many think so. For
example, the new German Finance Minister, Oskar Lafontaine, has said that his aim was a
"European monetary policy that supported growth and employment as well as price stability".
Nearer to home, the TUC has called for the MPC to be given a wider remit to include
employment as well as inflation. And several newspaper editorials have argued for a broader
remit for the MPC.
The fact that the proposition appeared in a newspaper does not of course mean that it is
necessarily compelling. As my newsagent told me the other day: "Don't believe everything you
read in the newspapers - they are all in the hands of the media."
The argument for including employment explicitly in the formal remit of the Monetary Policy
Committee is often bolstered by reference to the objectives of the Federal Reserve in the United
States, which is charged by statute with promoting "the goals of maximum employment, stable
prices, and moderate long-term interest rates". At first sight, this appears to contrast with the
remit of the MPC which is: "(a) to maintain price stability and (b) subject to that to support the
economic policy of Her Majesty's Government, including its objectives for growth and
employment". But what matters most is the intellectual framework underlying the behaviour of
the central bank. The Federal Reserve's remit does not make clear if the FOMC is supposed to
try to exploit some long-term trade-off between employment and inflation. But the practice is
clear. Under Alan Greenspan's leadership, the FOMC has firmly rejected the notion that by
accepting a somewhat higher rate of inflation it is possible to achieve a permanently higher level
of employment.
It is conventional to express the implications of a vertical long-term Phillips curve in terms of the
statement that unemployment can be held below the natural rate only by accepting accelerating
inflation - or, to be more precise, an inflation rate higher than anticipated by wage bargainers.
Equally, however, the statement can be turned the other way round. If the central bank is
successful in pursuing, over a number of years, a constant rate of inflation, then unemployment
cannot remain above the natural rate indefinitely. Not only can central banks not bring
unemployment down below the natural rate for long, neither can they be accused of keeping
unemployment persistently above the natural rate. Monetary policy cannot influence levels of
employment in the long run. There should be no surprise about this. A central bank can use its
chosen instrument - interest rates - to hit a nominal target - such as an inflation target, or a
target for the exchange rate or even the growth of nominal GDP - but it cannot use a nominal
instrument to target some desired level of a real variable, such as the growth rate of output or the
level of unemployment.
None of the above means that monetary policy has no impact on unemployment. To the contrary,
monetary policy does affect the movements of employment and unemployment over the business
cycle. And the remit of the MPC makes clear how we should take this consideration into account
- as I explained a year ago in a lecture at the LSE. By aiming consistently and symmetri