Jobs, output part of global business cycle

While economists often talk about the global business cycle, it is far less common to hear analyses of the global output or unemployment gap. There are good reasons for that.

Economies have very different potential growth rates, and these are much more difficult to estimate in emerging and developing economies where the bulk of the world’s population lives.

In addition, because strict migration controls keep most countries’ labor markets segmented from one another and labor market institutions vary so much, it is difficult to talk coherently about a global unemployment rate or a global natural rate of unemployment.

With the use of some fairly simple metrics, Standard Life Investments has made some general inferences about how much spare capacity there is in the global economy at present.

One measure of spare capacity is the degree to which global consumer price inflation is above or below its longer-term average. Standard’s own estimates, using GDP weights for the world’s 20 largest economies, show that in 2013 global inflation was 0.3 per cent percentage points (ppts) below its 10-year average, which would be consistent with the global economy operating modestly below potential.

Indeed, among the world’s 20 largest economies inflation was below average in 18, with only Brazil and Japan currently experiencing above-average inflation. The biggest inflation gaps are mostly in Europe, which is not surprising given the shocks the continent has experienced.

Another measure is the degree to which a GDP weighted unemployment rate for the same countries differs from its longer-term average. Again, there is solid evidence of spare capacity, with our global measure some 0.4 ppts above its 10-year average. However, the evidence is a little more mixed at the country level, as eight of the 20 countries currently have unemployment rates that are below their long-term averages.

With the exception of Germany, most of the low unemployment rate countries are emerging markets. This is consistent with Standard Life’s view that, after a decade of relatively strong growth, few emerging economies have room for significant policy stimulus and will therefore have to rely more on exports and structural reforms to drive growth higher from here.

In the United States, the aging population is putting the participation rate on a long-term downward trend, structurally lower labor turnover may have left the hiring and quits rates permanently lower, while hysteresis and geographic and skill mismatches mean that long-term unemployment will remain high and many of the affected workers will not exert much downward pressure on wages.

“Just as importantly, a forward-looking central bank should not wait until slack has been eliminated before beginning to normalize policy, particularly when the Federal funds rate is at least 3 ppts below its neutral level and the Fed is sitting on a $4 trillion balance sheet,” says Standard Life.

The euro zone labor market has turned, but a weak recovery means that employment growth is making few inroads into chronically high unemployment rates. Employment in the euro zone as a whole grew by 0.1 per cent quarter-on-quarter for the second quarter in a row in early 2014.

While it is positive news to see jobs being created, the pace of improvement is unimpressive. While it is edging up, employment remains some 3.7 per cent below its pre-crisis peak following a double dip recession in the currency union.

One area where emerging markets’ policymakers have attracted praise is in their efforts to improve their inflation-fighting credentials, with central bankers – most noticeably in Turkey, India and Brazil – taking steps to try to dampen upward price pressures. Tighter policy conditions would typically involve a trade-off between lower growth and higher unemployment. However, that has not been the case so far, with unemployment rates across the EM region remaining low compared to recent averages.

In China, the health of the labor market is harder to gauge. A number of official data releases point to a relatively tight labor market with the ratio of urban labor market demand and supply estimated to be close to record highs, while the urban registered unemployment rate stands at just 4.1 per cent.

However, it is questionable whether the apparent buoyant employment conditions are a true reflection of the underlying trends within the labor market. Certainly, the wage data appears to be displaying few signs of shortages, with wage growth continuing to moderate in line with the recent growth slowdown.

The specter of a tight labor market does not appear consistent with survey evidence either.

With educational levels and job aspirations among Chinese workers changing rapidly, there appears to be growing imbalances in the job market.

In particular, white-collar workers appear to be in increasingly plentiful supply, while shortages of non-skilled workers and those at the lower end of the labor market appear to be rising.

In this environment, Standard Life says the government technically has room to loosen policy without worrying excessively about a wage-induced rise in inflation. “However, loosening policy would probably exacerbate financial imbalances and delay the rebalancing of the economy. Better to accept lower growth now than generate a hard landing later.”