Supply and spare capacity

Section 3 of the Inflation Report - February 2019

The MPC judges that supply and demand in the economy were broadly in balance in 2018 Q4. Subdued demand growth over 2019 means that a degree of spare capacity is projected to emerge in the near term, however. Following the MPC’s regular reassessment of supply-side conditions, potential supply growth is projected to be a little weaker than previously anticipated. Over the forecast period as a whole, demand growth is projected to outstrip that subdued rate of potential supply growth such that a margin of excess demand builds.

The pace at which demand can grow without generating sustained inflationary pressures depends on the amount of spare capacity in the economy and the growth rate of potential supply. In turn, potential supply growth depends on structural features of the economy such as population growth and gains in productivity.

During the financial crisis, demand fell sharply, unemployment rose and a significant degree of spare capacity opened up. Potential supply growth also slowed as productivity growth stalled (Chart 3.1). In the years that followed, spare capacity was absorbed as demand grew faster than potential supply. The unemployment rate, for example, fell from 8% in 2013 to 4% by mid-2018 as companies increased hiring and reduced redundancies.

The MPC conducted its regular reassessment of supply-side conditions in the run-up to this Report. Spare capacity was judged to have been absorbed in 2018 Q4 (Section 3.1). Subdued demand growth over much of 2019 (Section 2), however, means that a degree of spare capacity is expected to emerge in the near term. The MPC judges that potential supply growth is likely to be slightly weaker than previously anticipated, at a little below 1½% in the central projection (Section 3.2).

The outlook for potential supply growth will be highly sensitive to the nature of the UK’s withdrawal from the EU. As described in Box 4 of the November 2018 Report, reductions in openness as the UK’s trading relationship with the EU changes are likely to reduce the economy’s productive capacity for a period of time. While such changes in supply could be relatively gradual in the event of a smooth withdrawal, a disorderly exit could severely impair the productive capacity of UK businesses.1

Chart 3.1

The MPC expects potential supply growth to be subdued
Output and decomposition of estimated potential supplya

Chart 3.1

  • Sources: ONS and Bank calculations.

    a Quarterly averages. Faded diamonds and bars are projections.
    b Chained-volume measure.

3.1 Spare capacity in the economy

The degree of spare capacity is an important determinant of inflationary pressures. When resources are underutilised — for example if many people are out of work or if companies have spare productive capacity — there tends to be scope for output to rise without generating excess inflationary pressures. But once spare capacity is absorbed, rises in demand tend to put greater upward pressure on wage growth and inflation as companies need to pay more to recruit and retain staff or invest in additional resources.

The MPC uses a range of approaches to estimate spare capacity. One ‘top-down’ approach is to use statistical filtering techniques to estimate spare capacity from past observations of GDP, taking into account indicators of domestic price pressures. Weakness in core services CPI inflation, one measure of domestic inflationary pressures (Section 4), suggests that there might be a small margin of spare capacity in the economy. Results from filtering techniques tend to be very sensitive to the precise modelling assumptions, however.

An alternative ‘bottom-up’ approach is to separately estimate the components of spare capacity within the labour market and within firms. The unemployment rate — a key component of labour market slack — was 4% in the three months to November (Chart 3.2). That is a little below the MPC’s assessment of the ‘equilibrium rate’ of unemployment consistent with inflation at the target (Section 3.2).

A range of other indicators are also consistent with tight labour market conditions. Survey indicators of recruitment difficulties are above their past averages and the ratio of redundancies to employees is close to its historical low (Table 3.A). While most surveys of employment intentions softened a little in Q4, consistent with a slight slowing in employment growth in early 2019, labour market conditions are projected to remain tight and unemployment is expected to be broadly stable in the near term (Chart 3.2).

Spare capacity also appears to have been largely absorbed elsewhere in the labour market. The ‘marginal attachment’ ratio — the proportion of the working-age population who are not currently in work or seeking employment but report that they would like a job — has fallen sharply in recent years to a record low (Chart 3.3). That suggests the scope for further rises in the employment rate as such people enter the labour market is likely to be limited. In addition, the number of hours that those in employment say they would like to work, over and above those they are currently working, has fallen back in recent years and has been close to, or a little above, zero in recent quarters.

A further component of spare capacity is the extent to which companies’ capital equipment, such as vehicles or computers, is being underutilised. Reports from the Agents suggest that companies are operating at a little below normal capacity, meaning that firms may have some scope to raise output with existing resources (Chart 3.4). Results from the CBI and BCC surveys, however, suggest that spare capacity within companies has been absorbed.

Based on the evidence from both the ‘top-down’ and ‘bottom-up’ approaches, the MPC judges that demand and supply were broadly in balance in 2018 Q4. Spare capacity is projected to emerge in early 2019 as demand growth remains subdued (Section 2). Further out, inflationary pressures are projected to build as demand growth picks up while potential supply growth remains modest (Chart 3.1).

Chart 3.2

The unemployment rate is expected to remain broadly flat
Unemployment rate and Bank staff’s near-term projectiona

Chart 3.2

  • Sources: ONS and Bank calculations.

    a The beige diamonds show Bank staff’s central projections for the headline unemployment rate for the three months to September, October, November and December 2018 at the time of the November 2018 Report. The red diamonds show the current staff projections for the headline unemployment rate for the three months to December 2018 and January, February and March 2019. The bands on either side of the diamonds show uncertainty around those projections based on ±1 root mean squared error of past Bank staff projections for the three-month headline unemployment rate.

Table 3.A

The labour market remains tight
Selected measures of labour demand and labour market tightness

Table 3.A

  • Sources: Bank of England, BCC, CBI, CBI/PwC, KPMG/REC/IHS Markit, ONS and Bank calculations.

    a Changes relative to the previous quarter. Figure for 2018 Q4 is Bank staff’s projection, based on data to November.
    b Other comprises unpaid family workers and those on government-supported training and employment programmes classified as being in employment.
    c Measures for the Bank’s Agents (split by manufacturing and services for employment intentions), the BCC (non-services and services) and CBI (manufacturing, financial services and business/consumer/professional services; employment intentions also include distributive trades) are weighted together using employee job shares from Workforce Jobs. BCC data are not seasonally adjusted. Agents’ data are the last available observation for each quarter.
    d The scores are on a scale of -5 to +5, with positive scores indicating stronger employment intentions over the next six months relative to the previous three months.
    e Net percentage balance of companies expecting their workforce to increase over the next three months.
    f Quarterly average. Recruitment agencies’ reports on the demand for staff placements compared with the previous month. A reading above 50 indicates growth on the previous month and below 50 indicates a decrease.
    g Vacancies as a percentage of the workforce, calculated using rolling three-month measures. Data start in 2001 Q2. Excludes vacancies in agriculture, forestry and fishing. Figure for 2018 Q4 shows vacancies in the three months to December relative to the size of the labour force in the three months to November.
    h Redundancies as a percentage of total LFS employees, calculated using rolling three-month measures. Figure for 2018 Q4 is for the three months to November.
    i The scores are on a scale of -5 to +5, with positive scores indicating greater recruitment difficulties in the most recent three months relative to normal.
    j Percentage of respondents reporting recruitment difficulties over the past three months.
    k Net percentage of respondents expecting skilled or other labour to limit output/business over the next three months (in the manufacturing sector) or over the next 12 months (in the financial services and business/consumer/professional services sectors).

Chart 3.3

The proportion of people not currently in work or actively looking for work, but who would like a job, has fallen
Marginal attachment ratioa

Chart 3.3

  • Sources: ONS and Bank calculations.

    a Number of those aged 16–64 who say they are not in work or actively looking for work but would like a job, as a percentage of the 16–64 population. As reported in the LFS. Rolling three-month measure.

Chart 3.4

Agents’ reports suggest that firms are operating at a little below normal capacity
Indicators of capacity pressuresa

Chart 3.4

  • Sources: Bank of England, BCC, CBI, CBI/PwC and Bank calculations.

    a Measures above zero indicate greater capacity pressures relative to past averages. Measures are produced by weighting together surveys from the Bank’s Agents (manufacturing and services), the BCC (non-services and services) and the CBI (manufacturing, financial services, business/consumer/professional services and distributive trades) using shares in nominal value added. Agents’ data are the last available observation for each quarter. BCC data are not seasonally adjusted.

Table 3.B

Monitoring the MPC’s key judgements

Table 3.B

3.2 Potential supply

The supply capacity of the economy is determined by the quantity of labour available and the amount of output that workers can produce. Potential supply growth has slowed sharply since before the financial crisis due to persistent weakness in productivity growth (Table 3.C). While that weakness has been partly offset by robust growth in labour supply, overall potential supply growth has been around half its pre-crisis rate in recent years.

Following its regular reassessment of supply-side conditions, the MPC judges that potential supply growth will remain lower than its pre-crisis average, at a little below 1½% per year on average. That is slightly slower than projected in the November Report.

Labour supply

Population and net migration

Population growth is a key driver of growth in labour supply (Table 3.C). Much of the UK’s population expansion over the past decade has reflected net inward migration, which peaked at over 300,000 per year in 2015–16 (Chart 3.5). While net migration remains higher than over much of the past decade, it has slowed since mid-2016 and was 273,000 in the year to 2018 Q2. That slowing was more than accounted for by lower migration from the EU; net migration from outside the EU rose to its highest level in over a decade.

The MPC’s forecast is conditioned on the ONS’s principal population projection, published in 2017. The projection implies a further slowing in net migration over the next three years, to 189,000 in 2021 (Chart 3.5). There are risks around that profile, however. Net migration in the year to 2018 Q2 was somewhat higher than the ONS’s principal projection, and that comparative strength could continue. But it is possible that these figures overstate the strength of net inward migration. Changes in employment by nationality from the Labour Force Survey (LFS) — an alternative source of data to those shown in Chart 3.5 — suggest that the number of EU citizens employed in the UK fell by 132,000 in the year to 2018 Q3.

Labour force participation

In addition to population growth, labour supply growth also depends on structural changes in the number of people who want to work — those either in work or actively looking for a job.

The participation rate has risen slightly in recent years, as the proportion of people wanting to work has increased within certain demographic groups (the beige bars in Chart 3.6).2 Improved health and longevity, as well as rises in the state pension age, have raised the participation rates of older workers. The proportion of women in or seeking work has also increased. Set against that, the rising average age of the UK population has pushed down the overall participation rate (the blue bars in Chart 3.6). Currently just over 10% of those aged over 65 participate in the labour market, relative to around 80% of those aged 16 to 64. These offsetting structural trends are expected to continue in coming years, such that the participation rate is projected to remain broadly stable.

Unemployment

The quantity of labour engaged in producing output will also depend on the equilibrium rate of unemployment. When unemployment falls below the equilibrium rate, wage and inflationary pressures will tend to build as companies need to pay more to recruit and retain staff.

The MPC judges that the equilibrium unemployment rate has fallen slightly in the past few years. In February 2018, it was estimated at around 4¼%. As discussed in previous Reports, the fall in the equilibrium unemployment rate is likely to have reflected structural factors such as changes to the tax and benefit system and an increased degree of educational attainment in the workforce.

The actual unemployment rate has fallen slightly over the past year (Chart 3.2), to a little below the MPC’s estimate of the equilibrium rate made in February 2018. The MPC judges that fall has reflected a cyclical rise in labour demand rather than a further fall in the equilibrium rate. The number of vacancies relative to the size of the workforce — a key indicator of labour demand — has risen to a historical high (Table 3.A). And the rate at which those already in employment are switching to new jobs — which will partly reflect the degree to which employers are competing to hire employees — has risen to close to its pre-crisis level (Chart 3.7). Stronger labour demand may also have reduced the job destruction rate since, in a tight labour market, workers become harder to replace (Chart 3.7).

The MPC judges that the equilibrium unemployment rate remains at 4¼%. That judgement is consistent with the recent strengthening in wage growth (Section 4), which has been slightly above the MPC’s projections in recent quarters and suggests that unemployment is close to, or below, its equilibrium.

Average hours

Besides changes in the size of the labour force, potential labour supply can be affected by changes in the number of hours people want to work. Some part-time workers, for example, may prefer to find a full-time job, while others may want to reduce their hours. These preferences can be affected by current and expected future incomes, as well as demographic factors such as age.

In the decades prior to the crisis, average hours worked fell as incomes rose, since people could maintain their level of spending while working fewer hours. During the crisis, however, the share of part-time employment rose markedly and employees reported that, on average, they wanted to work more hours. Consistent with that, the proportion of part-time workers who reported that they could not find a full-time job rose (Chart 3.8). Since then, hours worked have risen towards their ‘desired’ level as the proportion of people working part-time has fallen (Section 3.1).

The MPC judges that desired hours worked per week will remain broadly stable over the forecast horizon, reflecting two offsetting structural factors. A rising average age of the population is likely to depress desired hours worked, since older people tend to want to work shorter hours. But set against that, desired hours worked by women are expected to rise further as more women work full-time.

Productivity

In addition to changes in potential labour supply, potential supply growth depends on gains in productivity. The level of UK productivity per hour is only just above its pre-crisis peak (Chart 3.9). By contrast, productivity in many other advanced economies is now some way above its level prior to the crisis.

The openness of the UK economy and the size of its financial sector mean that global developments, such as slower world trade growth and financial sector deleveraging, are likely to have been particularly important in driving the slowdown in UK productivity growth. Based on current data, the manufacturing sector — which tends to be particularly exposed to global growth — and the financial services sector can account for over half of the weakness in UK productivity growth since the crisis (Chart 3.10).3

In the financial services sector, the apparent slowdown in productivity growth partly reflects unusually high measured productivity growth prior to the crisis, driven by higher leverage and risk-taking within financial firms. Mismeasurement of financial services output may also have contributed to the measured slowdown, by overemphasising the effects of higher leverage before the crisis and the effects of deleveraging since then. While financial services productivity growth could pick up relative to the period following the crisis, the pace of growth seen in the 2000s is unlikely to return.

In the manufacturing sector, part of the slowdown in productivity growth is likely to have reflected the weakness in world trade growth since the crisis. World trade growth tends to boost productivity through increasing economies of scale, competition and exposure to new ideas. Although world trade growth picked up through 2017, it has since slowed (Section 1). All else equal, any ongoing weakness will weigh on the outlook for productivity growth in the manufacturing sector.

Another way to examine the productivity growth slowdown is to use a standard growth accounting framework to split productivity growth into the amount of capital available per hour worked — ‘capital deepening’ — and the efficiency with which both capital and labour are used to produce output — ‘total factor productivity’ (Table 3.C). Results from this approach suggest that slower growth in capital deepening can account for a significant part of the weakness in productivity growth since before the crisis. That has reflected weak investment over much of that period. The remainder of the weakness in productivity growth has been the result of slower growth in the efficiency with which inputs are used. This may partly reflect a misallocation of capital across both companies and sectors.

There are some signs that total factor productivity growth could pick up in coming years. Research and development (R&D) expenditure — a key driver of innovation and hence productivity growth — has increased as a share of GDP over the past decade to its highest level since the early 1990s (Chart 3.11). The extent to which that pickup in R&D spending will boost productivity growth is uncertain, however, and depends on a number of factors including the extent of complementary investment in tangibles — for example information technology — and intangibles — for example training and management. Furthermore, new discoveries tend to take time to implement and evidence suggests it can take between two and six years on average to boost productivity growth within firms.4

While the pickup in R&D spending could boost productivity growth in coming years, many of the factors that have weighed on productivity growth over the past decade are expected to persist. Business investment growth is expected to remain weak in the near term (Section 2), which will reduce the extent of capital deepening. Changes in trading arrangements as a result of Brexit are also likely to weigh on the outlook for productivity, even under the assumption of a smooth adjustment to those new arrangements.

Overall, the MPC judges that productivity growth is likely to be slightly weaker than previously projected. That downward revision has been made in light of the unexpected weakness in productivity growth over the past year. Output per hour — which was expected to grow by 1¼% in the year to 2018 Q4 under the MPC’s February 2018 projections — is now estimated to have been broadly flat (Chart 3.12). Productivity growth is nevertheless projected to pick up to around 1% per year by the end of the forecast period (Section 5).

Table 3.C

Potential supply growth has been subdued since before the financial crisis
Decomposition of estimated potential supply growtha

Table 3.C

  • Sources: ONS and Bank calculations.

    a Contributions may not sum to the total due to rounding.
    b Positive numbers indicate that a fall in the equilibrium unemployment rate has increased potential labour supply.
    c The productivity decomposition is based on a growth-accounting framework using a constant returns to scale Cobb-Douglas production function, with the elasticity of output with respect to capital set to 1⅓. Total factor productivity is a residual.
    d Capital deepening refers to growth in capital services per person-hour. Capital includes structures, machinery, vehicles, computers, purchased software, own-account software, mineral exploration, artistic originals and R&D. Calculations are based on Oulton, N and Wallis, G (2016), 'Capital stocks and capital services: integrated and consistent estimates for the United Kingdom, 1950–2013', Economic Modelling.

Chart 3.5

Net migration is projected to fall from current levels
Decomposition of net inward migration by citizenshipa

Chart 3.5

  • a Rolling four-quarter flows. Data are half-yearly to December 2009 and quarterly thereafter, unless otherwise stated. Figures by citizenship do not sum to the total prior to 2012.
    b Data are half-yearly to December 2011 and quarterly thereafter.
    c Includes illustrative revised trend for the inward migration of non-EU students that accounts for an unusual pattern in the International Passenger Survey (IPS), represented by the faded beige bars.

Chart 3.6

The participation rate has risen slightly in recent years
Contributions to the change in the participation rate since 1992a

Chart 3.6

  • Sources: ONS and Bank calculations.

    a Percentage of the 16+ population. Decomposition calculated using published ONS age groupings.

Chart 3.7

Job-to-job flows have risen while the job destruction rate has continued to fall
Flows within employment and between employment and unemployment

Chart 3.7

  • Sources: ONS and Bank calculations.

    a Proportion of people who reported being in a job three months ago and report being in a job for less than three months. Ages 16 to 69. Two-quarter moving average.
    b Proportion of people who reported having moved from employment to unemployment in the past three months. Ages 16 to 64. Two-quarter moving average.

Chart 3.8

The proportion of part-time workers unable to find a full-time job has fallen in recent years
People working part-time who could not find, or did not want, a full-time job, as a proportion of part-time employmenta

Chart 3.8

  • Sources: ONS and Bank calculations.

    a Percentage of LFS part-time employment. Rolling three-month measures.

Chart 3.9

UK productivity has barely grown since the financial crisis
Hourly labour productivity in the G7a

Chart 3.9

  • Sources: Eikon from Refinitiv, Eurostat, ONS and Bank calculations.

    a Whole economy unless otherwise stated.
    b US non-farm output per hour.

Chart 3.10

Finance and manufacturing account for over half of the post-crisis weakness in productivity growth
Contributions to hourly labour productivity growtha

Chart 3.10

  • Sources: ONS and Bank calculations.

    a Annual averages. Sectoral output per hour is calculated as gross value added (GVA) divided by hours worked. Figures in parentheses are weights in nominal GVA in 2017. Data revisions in the 2019 Blue Book may result in changes to these estimates. For further details, see ‘Transformation of gross domestic product in Blue Book 2019’.

Chart 3.11

R&D expenditure has increased over the past decade
Research and development expenditure as a share of nominal outputa

Chart 3.11

  • Sources: ONS and Bank calculations.

    a Annual averages.

Chart 3.12

Productivity growth has stalled
Output per houra

Chart 3.12

  • Sources: ONS and Bank calculations.

    a Output is based on the backcast for the final estimate of GDP. The diamond shows Bank staff’s projection for 2018 Q4, based on labour market data to November and estimated GDP growth for Q4.
This page was last updated 07 February 2019
Was this page useful?
Add your details...