Saunders Sees Stronger UK Wage Growth in 2018, Warns on Potential for Further Interest Rate Rises

Above: We find Michael Saunders' assessment of the UK economy bullish for Pound Sterling's outlook. © Bank of England

"I consider it likely that interest rates will need to rise further over time"

The recent strong performance of the Pound extended mid-week with gains coinciding with the appearance of Michael Saunders, External MPC Member of the Bank of England, who says UK interest rates will likely have to rise faster than markets are currently anticipating in 2018 if his assumptions on the UK economy and pay trends are correct.

Delivering a speech at the Launch of the Financial Intermediary and Broker Association at BAFTA in London, Saunders says UK workers will likely see their pay-packets rise steadily in 2018 as workers from the EU opt to not come to the UK in the numbers they did before the Brexit vote.

Also driving pay higher will be a workforce more confident that it can shop around for work in order to derive higher wages.

Higher wages are inflationary and the Bank of England will therefore most likely need to respond by raising interest rates. Higher interest rates attract inflows of foreign investor capital seeking better yields, which in turn bids up the value of the Pound.

Hence, Saunders' speech is undoubtedly hawkish for Sterling. Saunder's comments were "credited for the latest run up and outperformance in the Pound," says Joel Kruger, an analyst with LMAX Exchange. "Though the central bank wasn’t entirely upbeat, his talk of more rate hikes over time and a rise in wage growth, were enough to get the market running."

It is hard to say there has been a sizeable move higher in the Pound because of Saunders' speech, but we do observe the currency is performing well and believe the speech will have added to the fundamental underpinning of the rally.  

The Pound-to-Euro exchange rate trades back above 1.13 at the time of writing while the Pound-to-Dollar exchange rate trades at 1.3844.

The Labour Market Will Keep Improving

Saunders has set himself out to be one of the more optimistic members of the Bank of England's Monetary Policy Committee with today's speech, making him someone we believe will vote for an interest rate rise at an early opportunity.

"In my view, the labour market currently seems likely to tighten more this year than the external consensus expects, with further declines in unemployment and under-employment," says Saunders who was the former UK economist of Citigroup until he joined the Bank of England for a tenure that lasts from 2016 through to 2019.   

The tightening labour market and rising recruitment difficulties probably will lift pay growth this year a bit above the recent subdued trends.

Unemployment has fallen steadily for over six years, with the jobless rate down from the peak of 8.5% in 2011 to just 4.3% late last year, the lowest since 1975.

"My hunch is that the labour market will probably tighten further this year, with the jobless rate dropping to - and perhaps even below - 4% during 2018, alongside further declines in under-employment," says Saunders.

In his view the economy and labour demand are likely to hold up a bit better than many expect, particularly amidst the soft sentiment regarding Brexit.

The economy is expected to grow between 1.5% and 2.0% in 2018 with growth supported by strong external global growth and strong household and corporate bank balances.

"Overall corporate and household balance sheets in the UK have improved significantly in recent years, with lower debt levels (relative to income) and higher holdings of liquid assets. Banks are better capitalised and hence more resilient. Money and credit are growing steadily, more or less in line with nominal GDP," says Saunders.

The economist believes background drivers are in place for a cyclical upturn in business investment, with the high return on capital, low cost of capital, and high capacity use.

"Even with Brexit uncertainties, business surveys suggest that investment intentions are around average," says Saunders.

EU Workers Avoid the UK, and this Could Boost Pay

Brexit has provided less incentive for workers from the EU to come to the UK,  because of the impact the fall in the value of Sterling has had on relative pay.

Supply of labour into the UK, particularly from the EU, has fallen sharply since the EU referendum, with Saunders noting, "Sterling’s Brexit-related
depreciation has reduced incentives to work in the UK – especially for people intending to send money home - because the UK’s relative wage levels have fallen in foreign currency terms"

But, the strengthening Eurozone economy means would-be migrants are finding it pays to remain where they are, "especially in the countries
that until recently saw outflows of workers," notes Saunders.

Saunders notes that even Germany, which obviously is not leaving the EU, has seen a sharp slowdown in the number of citizens from other EU countries in its workforce.

"I would not be surprised if they turn negative – i.e. more people leave than arrive - at some stage."

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Productivity to Pick up

Workers will need to justify higher pay packets with greater productivity in the workforce; something that has not been happening since the recession.

There are however signs that productivity is improving and Saunders argues   the UK is not inevitably locked into persistent low productivity growth.

"Technological innovation remains high and there is ample scope for UK productivity to catch up to the higher levels elsewhere, for example, the US and Germany," says Saunders.

More Pay Please

Saunders' hunch is that further tightening in the labour market and an increase in productivity is likely to cause underlying pay growth to pick up from about 2.25% recently to about 3.0% this year and probably a little higher next year."

"Year-on-year pay growth typically reacts to changes in the jobless rate with a lag of several quarters. As such, pay trends in 2017 probably tell us more about labour market slack in 2016 than in 2017. And these lags may currently be a little longer than usual."

Saunders observes that since the recession people have been too afraid to move jobs in search of higher pay, this has allowed employers to sit on staff without having to raise rates to keep them.

But, it is believed employees are starting to venture out and seek greener pastures, and this will in turn require employers to start digging deeper to hold onto staff.

"In recent quarters, the number of job-to-job moves has returned to something like the pre-crisis norm," says Saunders.

Another interesting point raised by Saunders is that employees might have received more than the headline pay rate suggests: "pay growth in recent years has understated the rise in total labour costs, with large rises in non-wage costs, including national insurance taxes28, contributions to DB pension schemes, auto enrolment, the Apprentice Levy and so forth."

Pay growth in 2018 is forecast to stay well below the pre-crisis norm of 4% or so. "But, I suspect it is more likely to overshoot than undershoot the external consensus (which is for AWE growth of 2.6% in 2018 and 2.8% in 2019)."

Lee Biggins, founder and managing director of CV-Library - one of the UK's largest online job sites - confirms this trend is taking place:

“Competition for the top candidates is tough, and this is reflected in the increase in advertised salaries last quarter. Though many companies might be reluctant to loosen the purse strings, it’s clear that offering competitive packages is important right now, especially given that unemployment is at its lowest in 42 years. Despite this, it’s great to see that businesses are remaining active in their recruiting efforts and hoping to encourage job hunters to begin moving around and looking for their next career opportunity.

Interest Rates to Rise

Saunders observations on the labour market lead him to believe that the economy can withstand - and in fact might require - higher interest rates.

"If the economy turns out broadly in line with the outlook I have described – labour market tightness and signs of higher pay growth - I consider it likely that interest rates will need to rise further over time," says Saunders.

Indeed, "There is considerable uncertainty over the exact level of interest rates that is neutral37, but I am fairly confident that we are below that level at present, especially if one allows for the stimulus from the stock of asset purchases. It follows that a modest further rise in rates would still imply a shift towards neutral, rather than an outright move to a restrictive policy stance."

On balance, we believe the first intervention by a Bank of England policy-setter in 2018, has turned out to be a positive one in terms of the British Pound's outlook.

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