JULY 07 Interest Rates A consensus has formed over the past six months that stronger global economic growth and falling unemployment will create inflation, meaning central banks will need to increase interest rates. Why does it matter? The level of interest rates is important because it determines the value of all major risk assets equities, real estate and bonds. If interest rates increase, the value of assets, particularly real estate and bonds, will likely fall. This reason for the market s emerging conviction that interest rates are going to rise is because strong economic growth has reduced the unemployment rate to a point where we would normally see wage inflation. Why do central banks worry about inflation? During the 960 s central bankers recognised that high inflation is detrimental to economic growth, particularly when inflation rates are high. After decades of experimentation, central banks began targeting inflation because they assessed that this was the best way of achieving price stability, which aids decision making ability in an economy. Targeting inflation has worked inflation has fallen, volatility of economic output has abated and interest rates have declined. The chart below shows the past 50 years of Australian interest rates, illustrating the effect of central bank inflation control. 6% Australian 0 year Government bond yield 4% % 0 years of falling interest rates 0% 8% 6% 4% % 0% 969 97 977 98 985 989 99 997 00 005 009 0 07 Around 60% of inflation comes from the labour market Anderson and Gruen (960) Monetary Policy Strategy, Frederic Mishkin, 009
Unemployment and inflation Traditionally, there has been a strong relationship between unemployment and wage inflation. The lower the unemployment rate, the higher wage inflation is. Wage inflation is important because more than 60% of inflation comes from the labour market, In line with this mindset central banks have long believed there is a level of unemployment at which there is no tendency for inflation to increase or decrease. This is called the natural rate of unemployment In the US economy, the average unemployment rate measured since 96 is 6.%. During the 980s and early 990s, most central banks placed the natural rate of unemployment near this rate, in the 6.0-6.5% range. So, if unemployment falls below this level, wages should grow strongly. The problem Central banks have a conundrum. They are mandated to act before inflation becomes a problem. Monetary policy must be pre-emptive, it must act well before inflation starts to rise 4. The problem is employment numbers tells us wages should be growing strongly, but they are not. Currently, the total unemployment rate in the U.S. stands at 4.5%, the lowest level in 5 years 5 yet wage inflation is running at less than.0%. The experience in other developed markets is even more pronounced. % US Unemployment Rate 0% 9% 8% No sign of infation The natural rate of unemployment is about 6%. If it falls below this level, wage inflation is expected to increase 7% 6% 5% 4% 987 99 995 999 00 007 0 05 The Phillips curve is a model describing a historical inverse relationship between rates of unemployment and corresponding rates of inflation that result within an economy The services industry is the most labour intensive industry and represents 75% of a typical advanced economies economic output. Source: Haver, UBS Federal Reserve Bank of San Francisco 4 Rethinking the role of NAIRU in Monetary Policy, Estella and Mishkin 5 Ibid
Wage inflation is not going up Without a meaningful acceleration in US wage growth it is unlikely that overall inflation rates rise much above the average central banks' % targeted inflation. If the labour market in the USA is around full employment, as May's 4. percent unemployment rate would indicate, why are we not seeing surges in wage growth and labour-force participation? 00% 50% 00% US Wages vs Productivity Hourly compensation There is a growing disparity between wages growth and productivity gains. Why? Productivity 50% 00% 50% 0% 948 95 956 960 964 968 97 976 980 984 988 99 996 000 004 008 0 The experience in other developed markets Below we provide direct quotes from the largest developed central banks, highlighting the lack of wages growth: Europe The European Central Bank says wage growth is the lynchpin of inflation. With Eurozone inflation stuck below.0%, the European Central Bank is looking to wage growth for any signs of emerging price pressures. Year on year hourly average wage growth at.6% in the Eurozone is well below the long-run average of.4%. The United Kingdom The labour force participation ratio and employment rate are both at all-time highs, yet annual wage growth has decelerated to just.0%, from near 4.0% in 05. Japan While the unemployment rate is at a 5-year low, there has been little acceleration in wage growth UBS Macro Keys German Wages Growth highest in the Eurozone, 4th April 07 CSFB Global Equity Strategy, June 07 Ibid
Why isn t wage inflation going up as expected? We argue that the primary reason for muted wage growth has been technological development. This dynamic is certainly not new, it has been a feature of economies since the beginning of civilisation. In 8 the Economist David Ricardo wrote about the impact of machinery that would reduce the demand for workers, leading to technological unemployment. Whilst he concluded progress is for the greater good, he noted that the substitution of machinery for human labour is often very injurious to the interests of the class of labourers. John Maynard Keynes in 90 also predicted the rapid technological progress of the next 90 years We are being afflicted with a new disease which we will hear a great deal in the years to come - namely, technological unemployment It is agreed the results of innovation and technology have been astonishing. In 500, real annual per capita incomes averaged $550, while today this number is on average $8,800 per annum 4. This enormous growth in wealth and living standards has been driven wave after wave of innovation or creative destruction. 5 The problem in today s economy may be the labour market is unable to evolve as quickly as technological progress requires. The chart below shows the cost trajectory of computing power since 990, illustrating the competition labour is facing. $,000.00 Global computing cost trends $ per MM of transistors (Log scale) $00.00 $0.00 $.00 $0.0 As computing cost as come down, it has enabled increasingly more complex tasks to be performed by computers. Source: Deloitte $0.0 990 994 998 00 006 00 David Ricardo, in the third edition of his Principles, Chapter, "On Machinery," 8 Ricardo versus Wicksell on Job Losses and Technological Change, Thomas M. Humphrey Robots and Jobs: Evidence from US Labour markets. Daron Acemoglu Pascual Restrepo Yale and Boston University, October 06 4 Maddison, World Economy, Volume, 6, 64, Gross National Income Per Capital 009, Atlas Method and PPP, the World Bank 5 Joseph Schumpeter, Capitalism, Socialism and Democracy, 94. Page 7
Technology and Labour The trend of technology displacing labour appears to be accelerating. Workers in an array of industries are becoming technologically unemployed. The World Bank estimates 57 percent of jobs in the OECD could be automated over the next two decades. McKinsey puts the same number at 45 percent While interesting forecasts, they are probably overly pessimistic. They do not account for the likelihood there will be jobs created from current industries transforming and brand new industries appearing. Nonetheless it is an indication of the disruption faced by the labour force because of technology. Robotics There are currently between.5 and.75 million industrial robots in operation, a number that could increase to 4 to 6 million by 05 Robots have been employed in manufacturing for decades. They have been the first modern wholesale application of technology to almost completely replace workers. Simply by doing jobs more cheaply and accurately than physical labour. Technological advances are contributing to increased performance and declining costs in robotics 4. Robots are now appearing in brand new fields. There are many studies that suggest the number of robots could quadruple by 05 potentially causing a decline of.8% in US employment and a.6% fall in wages 5. This is a meaningful impact on future wages growth as robots move into new areas such as retail and wholesale trade, and an array of service industries. World Development Report, 06 Boston Consulting Group, 05 IBA Global Employment Institute Artificial Intelligence and Robotics and Their Impact on the Workplace 4 McKinsey Global Institute 5 Robots and Jobs: Evidence from US Labour Markets, Acemoglu and Restrepo, March 07
The retailing industry We do not have the space to write about all emerging technologies impacting the labour force. To illustrate the impact of technology on wages growth we will focus on the retail industry. The retail and wholesale sector is one of the largest employers in any modern economy, employing between 0% to 5% of the labour force. The sector is undergoing well publicised disruption, known as the Amazon Effect. Amazon through its use of technology is lowering the cost structure of the industry as well as improving its service and convenience. Amazon and other online retailers now represent 8% of US retail sales having taken share from traditional retailers - causing bankruptcies and massive store closures. Simon Property Group $0 $0 $0 A major retail landlord $00 $90 $80 $70 $60 $50 Aug-06 Nov-06 Feb-07 May-07 CBL & Associates $5 $4 $ $ $ $0 $9 $8 A major retail landlord $7 $6 Aug-06 Nov-06 Feb-07 May-07 $80 $75 Target Corp Department store $60 $55 Kohl's Corp Department store $70 $50 $65 $60 $55 $50 Aug-06 Nov-06 Feb-07 May-07 $45 $40 $5 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Amazon are not limiting themselves to online, they are also transforming how traditional retailing is conducted. Last year Amazon opened a checkout-free store concept, called Amazon Go, in Seattle. These stores employ a walk out technology. Customers can use an Amazon application when they enter, pick up items from shelves, and exit without cash registers or lines. If this technology becomes universal, cashiers representing 5% of all retail workers - may be a relic of the past. It is not just cashiers that may become redundant, major retail chains are introducing robots and tablet based applications to replace customer service staff. Overall 0-50% of retail jobs are at risk, or 5% of the US workforce. Bureau of Labour Statistics Morgan Stanley, Retail Review, June 07
Conclusion Tepid wage inflation has many reasons, but the evidence suggests that the biggest influence is application of existing technologies to both augment human labour and completely replace it. We are not suggesting that we will see a wholesale increase in unemployment in developed economies. We are making the claim that bargaining power of labour will continue to be weak, and therefore wage growth will be muted. If wage growth is muted, overall inflation will remain below central bank targets and therefore they will not need to raise interest rates materially, despite stronger economic growth. From an investment perspective, low interest rates and strong economic growth combined are extremely positive for risk assets, particularly cyclical equities.
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