Supply and spare capacity

Section 3 of the Inflation Report - May 2019
  • Employment growth has been stronger than expected, despite relatively soft activity growth and Brexit uncertainties, and the labour market remains tight.

  • The MPC judges that a small margin of excess supply has begun to emerge in 2019, and that will persist in the near term. Thereafter, excess demand builds.

  • Productivity growth has remained weak. It is projected to continue to be muted in the near term before picking up gradually.


  • As discussed in the February Report, the MPC judged that demand and supply were broadly in balance around the turn of the year, based on the evidence from both statistical filtering techniques and the components of spare capacity. A small margin of spare capacity has begun to emerge in 2019, as underlying demand growth has been soft (Section 2), and this persists in the near term. Thereafter, demand growth rises above the modest rate of potential supply growth and excess demand builds (Section 5).

3.1 Labour market: developments and prospects

Recent developments

Since the February Report, the unemployment rate has fallen slightly, to 3.9% in the three months to February, as expected (Chart 3.1). That is a little below the MPC’s assessment of the equilibrium rate of unemployment — of 4¼% — that would be consistent with inflation at the target. A range of other indicators also point to labour market conditions remaining tight (Table 3.A).

Employment growth has been strong in recent months. Employment grew by 0.5% in the three months to February, and is expected to have grown by 0.4% in Q1 as a whole. This compares with a projection of 0.2% growth in the February Report. Over much of the past two years, employment growth has mainly reflected more full-time employees (Chart 3.2).

Alongside the rise in employment, the participation rate increased relative to three months ago — to 64.0% — and by more than had been projected. Part of this reflected revisions due to a reweighting of the Labour Force Survey (LFS) to take into account the latest population data. Much of the increase in participation in the labour market relative to three months ago was accounted for by those aged 50 and over. Participation is projected to remain at around current rates over the three years of the forecast period. This reflects the net result of two offsetting factors: the ageing of the population, which will tend to pull down on participation rates; and increases in participation within older age groups.

The strength in employment growth in recent months has occurred alongside soft demand growth, and has therefore been associated with sluggish productivity growth (Section 3.2). The employment strength contrasts with the weakness in investment growth (Section 2).

Brexit-related uncertainty is weighing on both investment and employment. Decisions to hire and invest both involve a degree of commitment, which means that there is value in postponing them in the face of uncertainty. However, this uncertainty is likely to be weighing more heavily on investment than employment, given that decisions about employment tend to be less costly to reverse.1

Responses to the Bank’s latest Decision Maker Panel (DMP) Survey are consistent with this: companies that report Brexit as a top-three concern have seen employment grow by slightly less (Chart 3.3), and investment grow by appreciably less, than those who do not. The size of this effect on aggregate employment growth is uncertain: analysis by Bank staff suggests that this could have reduced private sector employment by anywhere between ½% and 2% since the EU referendum, compared with an estimated 6%–14% reduction in investment from Brexit uncertainty. Companies that report that they have reduced employment because of Brexit have tended to do so through lower hiring rather than lay-offs (Chart 3.4).

The changing composition of new hires also provides evidence of how uncertainty appears to be affecting employment decisions. In the past, increases in uncertainty have tended to be associated with a greater proportion of temporary new staff placements relative to those that are permanent.2 The REC survey suggests this relationship has continued recently.

The strength of employment growth relative to investment growth does not appear to reflect individual firms employing more labour as a substitute for investment, according to responses to the latest DMP Survey. It is possible, however, that compared with the past, companies for which production is more labour-intensive have been growing more quickly relative to those for which it is more capital-intensive. To the extent that this has been the case, it might have contributed to the strength in employment growth relative to that of investment.

Near-term prospects

Most employment surveys have softened somewhat since the start of the year. In particular, the employment components of the monthly IHS Markit/CIPS and REC surveys have weakened materially (Chart 3.5). This might reflect soft GDP growth (Section 2). It may also be a consequence of companies finding it hard to recruit. Indicators of labour demand have remained strong — for example, the number of vacancies continues to be above historical levels — and that has been associated with surveys suggesting that recruitment difficulties remain elevated (Table 3.A). Further, the KPMG/REC Report on Jobs found that staff availability had continued to decline sharply, with recruiters citing Brexit related uncertainty, fewer EU workers and a high employment rate as factors.

The recent softening in the surveys stands in contrast to the official estimates of strong employment growth in the three months to February, although such divergences are not uncommon. Both the employment surveys and the LFS are subject to sampling variability that may cause estimates to differ from actual employment growth. The LFS response rate has been declining in recent years which may have increased this variability.3 However, the surveys may be erratically weak and recover as Brexit uncertainty wanes. For example, immediately after the EU referendum, a number of surveys fell sharply, while the official data they relate to did not.

The surveys may also contain some signal about future employment growth, which appears to have been the case at points in the past (Chart 3.5). Given that, employment growth is projected to slow in Q2, although it is expected to pick up a little thereafter.

Chart 3.1

The unemployment rate has fallen to 3.9%, and is expected to decline a little further in Q2
Unemployment rate and Bank staff’s near-term projectiona

Chart 3.1

  • 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 December 2018 and January, February and March 2019 at the time of the February 2019 Report. The red diamonds show the current staff projections for the headline unemployment rate for the three months to March, April, May and June 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, British Chambers of Commerce (BCC), CBI, CBI/PwC, ONS and Bank calculations.

    a Changes relative to the previous quarter. Figure for 2019 Q1 is Bank staff’s projection, based on data to February.
    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 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 Proportion of people who reported being in a job three months ago who report being in a job for less than three months.
    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 2019 Q1 shows vacancies in the three months to March relative to the size of the labour force in the three months to February.
    h Redundancies as a percentage of total LFS employees, calculated using rolling three-month measures. Figure for 2019 Q1 is for the three months to February.
    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 twelve months (in the financial services and business/consumer/professional services sectors).

Chart 3.2

Employment has been strong in recent months
Decomposition of change in employmenta

Chart 3.2

  • a Three months on previous non-overlapping three months.
    b Comprises unpaid family workers and those on government-supported training and employment programmes classified as being in employment.

Chart 3.3

The DMP Survey suggests that Brexit uncertainty has had a modest negative effect on employment growth
Average annual growth in employmenta by degree of concern about Brexitb

Chart 3.3

  • Sources: DMP Survey and Bank calculations.

    a Two-quarter moving average. Annual growth in employment is estimated from the number of people businesses report they currently employ (including part-time), and how many people they report employing 12 months ago.
    b Respondents were asked ‘How much has the result of the EU referendum affected the level of uncertainty affecting your business?’.

Chart 3.4

Uncertainty has affected hiring more than lay-offs
Impact of Brexit on employment, and the margin of adjustmenta

Chart 3.4

  • Sources: DMP Survey and Bank calculations.

    a Respondents were asked: ‘Looking back, could you say how the UK’s decision to vote ‘leave’ in the EU referendum has affected your overall employment, recruitment of new employees and lay-offs of existing employees since the referendum?’.

Chart 3.5

Employment surveys have weakened, in contrast to the official data
Employment growth and monthly surveys of employmenta

Chart 3.5

  • Sources: Bank of England, IHS Markit/CIPS, KPMG/REC Report on Jobs, ONS and Bank calculations.

    a Surveys of employment intentions have been adjusted to match the mean and standard deviation of official employment growth since January 1998.
    b Recruitment agencies’ reports on the demand for staff placements compared with the previous month. Produced by weighting together survey indices for permanent and temporary placements using employment shares.
    c PMI composite employment index.

3.2 The outlook for potential supply

In its annual reassessment of supply-side conditions in February, the MPC judged that growth in the potential supply capacity of the economy — which is determined by the quantity of labour available and the amount of output that those in employment can produce — was likely to remain modest, averaging around 1½% in the central projection.

Labour supply growth was projected to be subdued relative to recent years (Table 3.B), with almost all of it expected to come from population growth. 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 few years, to 189,000 in the year to 2021 Q2 (Chart 3.6). In the latest data, net migration was 283,000 in the year to 2018 Q3, somewhat higher than the ONS principal projection. Net migration from the EU continued to decline as it has done since the referendum, reflecting both lower inflows to the UK and increased outflows. Intelligence from the Bank’s Agents suggests that this decline in EU migration has exacerbated labour shortages in some sectors.4

In February, the MPC revised down its near-term projections for productivity growth. Over the past decade, much of the weakness in UK potential supply growth relative to the decade prior to the crisis can be accounted for by slower productivity growth (Table 3.B), which has often been weaker than projected (Box 6). Since February, productivity growth has remained weak: in the year to 2019 Q1 it is estimated to have increased by 0.7% on a per-head basis and decreased by 0.1% when measured per hour (Chart 3.7).

In the MPC’s projections, four-quarter potential productivity growth picks up gradually to around 1% towards the end of the forecast period (Section 5). The improvement in productivity growth is supported by higher investment, and also reflects an expected increase in the efficiency with which capital and labour are used to produce output — total factor productivity growth. That could be boosted by higher research and development expenditure over recent years.

The outlook for productivity growth is likely to be sensitive to the nature of the UK’s future trading relationship with the EU. As described in the box on pages 31–32 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 emerge relatively slowly in the event of a smooth withdrawal, a disorderly exit could severely impair the productive capacity of UK businesses.5

Table 3.B

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

Table 3.B

  • Sources: ONS and Bank calculations.

    a Average percentage point contributions to annual growth unless otherwise specified. Contributions may not sum to the total due to rounding.
    b Percentage changes on a year earlier.
    c Positive numbers indicate that a fall in the equilibrium unemployment rate has increased potential labour supply.
    d The decomposition is based on a growth-accounting framework using a constant returns to scale Cobb-Douglas production function, with total output to capital elasticity of ⅓. Total factor productivity is a residual.
    e 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.
    f Total factor productivity growth refers to improvements in the efficiency with which both capital and labour are used to produce output.

Chart 3.6

Net migration from the EU has slowed
Decomposition of net inward migration by citizenshipa

Chart 3.6

  • 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 adjustment to non-EU student migration data due to an unusual pattern in the International Passenger Survey data. See the ONS guidance note for more details.

Chart 3.7

Productivity growth has remained weak
Measures of labour productivitya

Chart 3.7

  • Sources: ONS and Bank calculations.

    a Output is based on the backcast for the final estimate of GDP. Diamonds show Bank staff’s projections for 2019 Q1, based on data to February.

Table 3.C

Monitoring the MPC’s key judgements

Table 3.C

This page was last updated 02 May 2019
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