This so called “productivity puzzle” – why the UK’s productivity had fallen so far and had not recovered – was a major part of the uncertainty the Committee faced about how fast the UK could grow without generating inflation pressure. If some or all of that lost productivity growth could be recovered, the economy could grow faster and for longer without putting the inflation target in jeopardy. But looking forward the Committee took a cautious view and based its view of the future on the expectation that productivity growth would recover only slowly and that none of the “lost” productivity would be recovered. Third, the MPC was operating under the “forward guidance” it had agreed in August last year and to which I had subscribed on joining the Committee. The underlying concern behind forward guidance was that the market might react too quickly and too simplistically to strong GDP growth numbers and forget the amount of spare capacity still in the economy. If the market predicated the Bank’s reaction to strong growth on a pre-crisis basis and, incorrectly, began to price in a tightening of policy the recovery could be choked off. To head off that risk the Committee had, earlier in the year, made clear its intention, through “forward guidance” not to consider tightening policy at least until there was a substantial reduction in spare capacity as evidenced by a fall in the unemployment rate to below 7%. So, over the subsequent year what have we learned? Have the puzzles and uncertainties resolved themselves?
Even adjusting for that effect though, unit labour costs look broadly flat – much below the 2% rate of increase we need to meet the inflation target in the medium term. The big surprise, therefore, for the MPC – and it is a positive, if puzzling, development – has been the extent to which employment has been able to grow without generating clear inflationary pressure. Understanding why that has happened and how long it will persist is, in my view, now key to deciding policy. One possible explanation is simply a longer-than-usual lag between falls in unemployment and pay pressure emerging. Once you take into account productivity, the unexplained weakness in wages only really materialised over the last three quarters, a period over which unemployment was falling very rapidly. Some survey measures suggest the pay of newly hired employees is growing at a much faster rate, of between 2% and 6%, rather than the 1% rate seen across employees as a whole in the official data. On this view, a rapid pick up in average pay levels is in prospect, once more and more workers start to shift jobs and as pay of existing employees is adjusted in annual pay rounds. The parable of the rock pulled by the elastic band is a very relevant one in economic policy making: the rock may not move for a long time, but eventually it will. And the longer it takes to move the faster the move is likely to be.