Recession threat

Has the Bank gone barmy? Is the City serious? The latest data shows that wage rises have declined - and will go down again next month. Retail price inflation has dropped too. Against expectation, claimant unemployment also seemed to have fallen by 26,000 - to its lowest level in 6 years. Ministers called this a "big setback for the doom and gloom merchants."

But the Bank of England - launching its Inflation Report on the same day as the labour market data release - commented that the figures continued to show signs of tightness in the labour market. The Inflation Report says that unemployment "has reached a level likely to prove incompatible with price stability". The Bank's Monetary Policy Committee (MPC) has stubbornly refused to rule out further interest rate rises claiming the inflation outlook remains "uncertain".

Deputy Governor, Mervyn King announced that unemployment had fallen below its "natural level" the dreadfully acronymed "NAIRU". He coyly avoided saying what the natural level is. With two different unemployment numbers currently available - 1.3 million by the Claimant Count or 1.8 million by the Labour Force Survey - a half million margin of error must be in play.

King is probably paying too much attention to the Claimant Count - a simple but avoidable error. Labour Force Survey-based measures are better indicators of unemployment than the Claimant Count. The MPC, City and academic economists need to get wise to this. Just because the LFS is described as the "Government's preferred measure" doesn't mean it's dodgy. The very opposite. If the economic effect of higher unemployment is to restrain what used to be called cost-push inflation, then a measure of how many people are outside a firm's door wanting jobs is better than one that relates to benefit status.

So the Bank would like to see unemployment rise to help meet the inflation target, and will change interest rates to achieve this. This view was supported by Goldman Sach's chief economist Gavyn Davies - when Davies speaks you can be sure that Gordon Brown is listening. He has declared that half a million job losses are needed to keep a lid on inflation. Much of the City seems to agree.

We disagree. Firstly, the politics make no sense. Are decision takers really proposing to push Britain into recession? Just to stick with the masochistic discipline of a 2.5% inflation target? And are Labour politicians going to let their opponents roll out another "Labour isn't working" jibe? It can take over a year to turn a recession around. Then it takes a year before employment recovers. Next, it takes a year for the electorate to believe it. Then it's election time.

People expect unemployment hikes from the Tories. But not from Labour. And in the run-up to the Party Conference, does Labour's leadership really want to unleash hostility amongst the Constituency membership? Mr Blair wants a relationship of trust between Government and Party - hence the reforms of recent years. But a swift bout of rising unemployment could easily recreate the disharmony which characterised the 1970s.

Secondly, the facts do not justify this analysis. Across the UK, unemployment actually went up in the last month. And across much of Northern Britain, the number of people in work has fallen. So, if the labour market has just peaked, then commentators are wrong to assume that the economy is overheating and calling for further deflationary measures.

The labour market is on a knife edge. But we are not engaged in "doom and gloom" for the sake of it. The new Government has launched the most effective and determined anti-poverty plans seen for over a generation: the New Deal and other specific programmes for the unemployed; enforcing new basic standards in the workplace; a minimum wage; investment in lifelong learning; wide-ranging reforms to tax and benefits. All this could go down the tube if the Treasury, the Bank and the City contrive to tip the country into a "mild recession" - where the economy is still growing but at too slow a rate to sustain job growth.

This is an early warning for policy makers who need to recognise the features of a labour market that is poised on a knife edge - before they become settled trends.

The Government has a double problem. Firstly, it needs policy instruments which have a differential impact on a "2 speed" country. Interest rate hikes which restrain growth in the South impact hard on the North whilst exchange rate policy that has little effect on service industries causes mayhem in manufacture.

Secondly, two policy levers are denied to the Government. Interest rates are now in the hands of the Bank's MPC whilst tax increases are subject to political self denial. Meanwhile the broad outline of increased Government spending has been set - and neither the City nor the Bank's MPC really liked it. Supply side measures are much favoured by Ministers but, although likely to succeed, take a long time to produce effects.

That leaves the Government with only one effective measure left: talking-up the economy.