Standard Life Investments

Weekly Economic Briefing


Searching for potential


We have seen an unusual dynamic taking hold in the UK over the first half of 2017. On the one hand, a range of activity data suggests that growth has been slowing. GDP increased by a sluggish 0.2% quarter-on-quarter at the start of the year while the trends in industrial production, construction and retail spending have all been lukewarm in Q2. On the other hand, the UK has been creating new jobs at a rapid clip, despite this less favourable backdrop. Indeed, last week’s labour-market report showed an increase in employment of 175,000 over the past three months, equating to an impressive annualised growth rate of 2.2%. Part of the discrepancy between growth and employment can be addressed by looking at the trend in total hours worked, which has been noticeably weaker, suggesting that while headcount is rising, firms are not employing labour as aggressively. However, even accounting for this, the combination of soft activity and robust labour market suggests further disappointments on the productivity side and raises concerns around the underlying growth potential of the UK economy.

Labour force chugging along A productivity drought

The supply side of the economy is notoriously difficult to measure and there is a range of views around UK potential growth. For example, the Office for Budget Responsibility (OBR) estimates that the productivity capacity of the economy will increase by 1.9% in 2017. Meanwhile, the OECD is noticeably more pessimistic, arguing that potential output will grow by just 1.3%. What these forecasters have in common is the view that potential growth has slowed very noticeably over recent years. Identifying where this shortfall has originated is easy. Growth in the labour force, one of the key building blocks of potential, has remained solid on account of consistent population growth and a small rise in participation (see Chart 3). Instead it is productivity which takes much of the blame. Headline labour productivity grew on average by 2.5% annually in the decade leading up to the financial crisis, but has stagnated over the past five years (see Chart 4). Low levels of investment and capital deepening in the wake of the crisis (and beyond) explain some of this shortfall. However, the majority of the disappointment stems from a significant deterioration in total factor productivity (the efficiency with which labour and capital are combined). This seeming productivity drought has been a powerful drag on the UK’s growth potential.

Will this persist? The OBR highlights the uncertainty around productivity, but expects this to improve over coming years, helping to support a potential growth rate of around 2% (even as labour-force growth slows). We would view the risks to this forecast to the downside. Indeed, there is little evidence that the government is taking proactive and aggressive action to help offset the recent deterioration in productivity. We have repeatedly argued that large-scale and targeted investment in public infrastructure, increased spending on education and reform in key sectors is needed to help address this issue. The UK’s exit from the European Union adds to uncertainty around potential growth. The impact of any change in the relationship with the EU on trade, investment and migration patterns could all affect how potential evolves. Given the recent disappointing trends it is important that the government looks to minimise any negative effects exit might have on long-run growth.   

James McCann, Senior Global Economist