The squeeze on UK wage earners and the global tightening in monetary liquidity

I mentioned in yesterday’s daily that a recent article in the Guardian on a post-Brexit vote labour supply shock in the UK was missing the key element of wage stagnation. So it’s interesting to see the Guardian highlighting how inflation-adjusted wage growth is diminishing, even as data released today reveal that unemployment rates in the UK has hit a 43 year low.

UK real wages falling again

Here’s how the Guardian puts it:

Pay growth in Britain has slowed to its weakest in almost a year despite a fall in the jobless rate to a fresh 43-year low and the biggest annual drop in workers from the EU since modern records began more than two decades ago.

Figures from the Office for National Statistics (ONS) showed wage inflation cooling in the second quarter of 2018 even though unemployment fell from 4.2% to 4.0% – its lowest level since the winter of 1974-5.

The trend in earnings confounded predictions from the Bank of England that a tighter labour market would intensify pay pressures and brought Threadneedle Street’s decision to raise interest rates earlier this month under fresh scrutiny.

I don’t think this is quite right. The Bank of England is using a Phillips Curve framing to justify rate hikes. They are not just saying that low unemployment will cause wage growth to rise. More importantly, they expect inflation to rise, which it has done. The problem is that wage growth has stagnated, leaving wage earners worse off.

Here’s the accompanying chart.

Wage earners have had a rough go since 2008

Now, if you look at the numbers, from the period after the financial crisis, UK wage earners were losing ground to inflation.

Source: Stephen Machin – Understanding the Great Recession: From Micro to Macro Conference, Bank of England, September 23 and 24 2015

The Bank of England knows this since I got the chart above from one of their 2015 conferences. Yet only recently has the BoE begun to normalize rate policy. In fact, if you look at the aggregate loss of real wages, the UK was the worst in the OECD after Greece in the post-crisis period. It was the worst decade for British workers in 70 years, with the brunt of the impact felt for millennials and Gen X.

Outlook: this is the beginning of a global tightening

So what is a central bank to do given how long it has taken to feel comfortable normalizing policy? If you look at my daily this morning and what economists are saying, you can see the biggest worry is central bank policy.

And I think that’s right. The withdrawal of monetary accommodation has proceeded in three phases. First, there was the end of quantitative easing and the resultant Taper tantrum that rattled emerging markets because of the dependence on US dollar liquidity. We sailed through that period largely unscathed. In fact, EM credit growth increased once the markets moved back to a risk-on stance.

In the second phase, the Fed began to raise rates. And rather than collapse, emerging market currencies strengthened. Money flowed into emerging markets as debtors pulled forward credit demand in anticipation of further tightening. This was the Goldilocks period for EM.

But when Jerome Powell took over as Fed chairman, a third, more sinister phase began for EM because it meant the end of dollar liquidity. Even though the Fed is still using a measured approach in raising rates, the bias is toward tightening and the surprises in rate policy are to the upside as the US economy continues to do well.

The fourth phase is when the BoE and the ECB join the Fed in withdrawing liquidity. And we look to be almost there. Emerging market currencies are falling as a result and eventually there will be an accident. To my eyes, the panics in Argentina and Turkey are a harbinger of more volatility to come. EM is feeling the pain first, but eventually the scope of risk realignment will hit high yield and then risk assets as a whole.

And note, when crisis does come, there is usually a flight to quality. And that means currencies like the Japanese yen, the Singapore dollar and the Swiss franc where there are huge current account surpluses. But it also means a flight to the US dollar because of its reserve currency status. And that will exacerbate problems for US dollar debtors.