The UK’s long productivity stagnation might be coming to an end. Latest official figures show that hours worked fell 0.4 per cent in the three months to April. With the NIESR estimating that GDP was flat then, this implies a 0.4 per cent rise in GDP per hour worked. This isn’t hugely impressive. But it raises hopes that the decade-long flatlining in productivity might be over.
If this is the case – and it is only an if – it would be good news for savers. This is because, over longish periods, faster productivity growth should mean higher real interest rates.
It is no accident that years of flat productivity has given us lousy interest rates and low bond yields. There are three reasons why the two are linked.
One is that low productivity growth means weak real economic growth. This should cause investors to fear low growth in dividends, which should increase their demand for safe assets such as bonds and cash. That will drive down expected returns on the latter.
Secondly, if economic growth is low the Bank of England will have to keep monetary policy loose to support the economy.
Thirdly, low productivity growth is usually associated with low capital spending. This can be because low spending is a cause of low productivity growth. Or it could be that if companies anticipate low growth, they’ll be disinclined to invest. Whichever it is, weak capital spending means there’ll be little demand for credit from firms and this too will hold down interest rates.
Theory, then, seems clear. Do the facts corroborate it?
Certainly, the productivity slowdown in the 2000s and 2010s coincided with a decline in index-linked gilt yields: longer-term yields were 3-4 per cent in the 1990s but minus 1.5 per cent in recent months.
However, index-linked yields were only launched in 1981. This gives us little data with which to compare trend productivity growth to real yields. If we want more data, we need a different measure of real yields. My chart uses one such. In it, I measure real yields as the difference between nominal yields on consols (undated gilts) averaged over 10 years and average CPI inflation, taken from Bank of England data.
This chart shows that there is indeed some link between productivity and real yields. Both rose in the 50s and 60s; both fell in the 70s; were stable in the 90s; and both have fallen this century. That’s what theory predicts.
There is, however, a big exception here. Real yields rose sharply in the 80s although productivity didn’t. I suspect there’s a simple reason for this. In 1981 the government relaxed controls on mortgage lending, causing a big rise therein. Rationing by quantity was replaced with rationing by price – which meant higher real interest rates. This was a one-off change that temporarily broke the relationship between productivity and real yields, but which doesn’t imply any breakdown in the relationship in future.
Generally speaking, then, the facts corroborate the theory that weak trend productivity growth should mean low average real yields and higher productivity growth higher yields.
How might this not be the case?
One possibility is that weak productivity might cause the Bank of England to raise Bank rate in an effort to control inflation: one reason for doing so would be the fear that even a small rise in wage growth would be inflationary if not offset by efficiency gains.
This, however, might not mean a large or sustained rise in short-term interest rates and hence not much of a rise in longer-term real interest rates. This is because higher real rates reduce inflation by depressing real growth and hence creating spare capacity in the economy. When productivity growth is low, however, so too is average economic growth. Which in turn means that even moderate rate rises threaten to cause recessions. This limits how much short rates can rise, and puts a cap upon longer-term gilt yields: the possibility of recession would cause investors to buy gilts.
We can think, therefore, of productivity as setting the climate for real yields rather than the weather. Over short periods, the weather can change for all sorts of reasons. Over longer periods, though, the climate sets the weather.
It’s in this context that any signs of rising productivity are to be welcomed. If productivity does show a sustained pick-up, it should imply higher interest rates and ultimately better returns on financial assets generally.
That word “ultimately” is doing some work however. In the near-term faster productivity might well cause a sell-off in bonds and hence losses for their holders. And it’s possible that this, plus better returns on cash, might unsettle equities. These, however, would be temporary teething troubles. In the long-run by far the best assurance of decent returns on equities is not cheap money but sustained economic growth driven by productivity improvements. Whether we’ll actually get this is, however, most uncertain.
