Can macroeconomic policy ensure the inflation target?

Dec 1, 2020

If Australian wages do not increase sufficiently in line with economic capacity, it risks a shortfall in aggregate demand that will make the achievement of an inflation target very difficult, or even impossible.

Credit – Unsplash

In announcing the most recent monetary policy package, the Governor of the Reserve Bank (RBA) made it clear that “The Board will not increase the cash rate until actual inflation is sustainably within the target range” of 2-3 per cent. The Governor then went on to say that “For inflation to be sustainably within the target range, wage growth will have to be materially higher than currently. This will require a lower rate of unemployment and a return to a tight labour market.”

Presumably, the RBA Board considers that the same strictures should apply to fiscal policy – after all, the RBA is on record as believing that fiscal policy must bear the main burden of supporting the economy now that interest rates are at rock bottom. Thus, by implication, the Budget should continue to support aggregate demand until the economy is close to full employment and wage growth has picked up to a level consistent with price inflation running at between 2 and 3 per cent.

But how low will unemployment need to fall to achieve that outcome, and will the return to full employment be sufficient to ensure the pickup in wage increases consistent with achieving the RBA’s target?

Macroeconomic policy advice in Australia (and elsewhere) has been built around the assumption that there is a stable relationship between the level of unemployment and the rate of inflation of both wages and prices – the so-called Phillips curve, named after the economist (and engineer) who first measured this relationship. The target rate of unemployment, the “NAIRU”, is then defined as the rate of unemployment consistent with achieving the authorities’ target of a low and stable rate of inflation of between 2 and 3 per cent.

However, as John Kay and Mervyn King have emphasised in their new book, Radical Uncertainty: Decision-making for an unknowable future”, there are good reasons to doubt that any such stable relationship between unemployment and inflation will be sustained over time.

As Kay and King point out, expectations about future inflation and the way these expectations are formed will influence this relationship, but there are good reasons for thinking that these expectations are not stable over time. During the golden era of the 1950s and 1960s, these expectations increased substantially in response to the continuous rise in living standards. But expectations have gradually adjusted downwards since the era of stagflation in the 1970s and 1980s, and more recently, the Global Financial Crisis and relative economic stagnation since appear to have significantly impacted expectations for wage and price inflation.

But I would argue that the Australian authorities have been slow to recognise how impermanent this relationship between unemployment and inflation actually is. Thus between 2011 and 2019 the RBA persistently overestimated wage growth by about 1 per cent, while the annual wage growth has been steadily declining from about 4 per cent in 2011 to around 2 per cent in the last few years, and even less in the last twelve months.

Nevertheless, despite their poor forecasting record, the RBA continued to argue that the relationship between inflation and unemployment was stable and that the NAIRU had not changed from their estimate of around 5 per cent. But with unemployment back to 5 per cent in early 2019, and the consumer price index increasing at an annual rate of less than 1½ per cent, the RBA finally decided in June last year that the NAIRU must have fallen to what the RBA now estimates to be an unemployment rate of 4½ per cent. A convenient assumption that any shortfall in the rate of wage increase must, by definition, reflect a lowering of the NAIRU.

But there are other structural reasons to believe that the stagnation in wages growth over the past decade or more, is not just a function of the degree of slack in the labour market.

Most importantly, as Stephen Bell and I have argued in our book, Fair Share: Competing Claims and Australia’s Economic Future, technological progress has impacted the labour market, changing the nature of different jobs and the structure of jobs. These changes in the structure of the labour market, have changed the distribution of national income between labour and capital, and also the distribution within labour earnings, and have inevitably disrupted the previous relationship between inflation and unemployment.

In addition, there have been institutional changes that have also changed the structural relationship between unemployment and the rate of wage inflation. Trade union membership has declined dramatically over the last three decades and the legislative framework that governs wage bargaining is arguably less favourable to workers’ claims.

For these various reasons, there must now be some doubt as to whether a return to a low rate of unemployment, consistent with the latest estimate of the NAIRU, can realistically be expected to also see a return to an inflation rate consistent with the target increase of between 2 and 3 per cent.

So why does this matter? As the Governor of the RBA said three years ago: “The crisis really is in real wage growth”. If real wages do not increase sufficiently in line with economic capacity, then we risk a shortfall in aggregate demand that will make the achievement of an inflation target very difficult, or even impossible.

If, however, there are other structural reasons that also help explain the sluggish wage growth, then relying only on macroeconomic policy could lead to unfortunate consequences. If pursued to its end the labour market may have to be so tightened that severe shortages of labour emerge in at least some industries and occupations before wage and price inflation return to their target range.

Given these risks, government policy should first start by not automatically opposing all wage increases as if they were the cause of future problems, when in fact they are a necessary part of the solution to achieving the desired increase in aggregate demand. The government needs to remember that while wages represent a cost to the individual employer, for the economy as a whole, wages are the principal source of income and demand. Therefore, instead of the present policy of opposing all wage increases, the government should use what direct influence that it has over wages by supporting reasonable claims by its own employees for regular pay increases and supporting an increase in the minimum wage.

Second, fiscal policy needs to be better targeted so that it directly addresses the issues of income distribution that are impeding the necessary increase in aggregate demand. How this can be done will be further discussed in a follow-up article tomorrow. But what we do know from experience is that relying on monetary policy alone to achieve an inflation target has a proven record of failure because the underlying relationships keep changing.

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