Inflation is starting to come down. The main reason cited for a further increase in interest rates is the fear of a wage-price spiral. But this is no longer likely. Instead, it is time for a pause in interest rate rises to better assess the future economic outlook.

Over the last year inflation has been the principal macroeconomic problem and the focus of monetary policy by the Reserve Bank (RBA).

In early May last year, on the eve of the Federal election, the RBA started on its plan to increase interest rates from what had then been an all-time low rate of 0.1 per cent for the cash rate. By the beginning of June this year, the cash rate was four percentage points higher at 4.1 per cent just about the biggest increase in interest rates over the shortest time in history.

So, what can we expect, or more to the point, what should result when the RBA Board meets next Tuesday to determine interest rates for the next month ahead.

Recent history

There is no doubt that inflation is still too high, but it has probably peaked. In the year ending in the last December quarter, the consumer price index increased by as much as 7.8 per cent well outside the RBA target range of 2-3 per cent. But the March figure gives some hope that the higher interest rates are starting to bite, and that inflation is falling, with the CPI only increasing by 7.0 per cent over the year to March.

Furthermore, the less reliable monthly CPI indicator only rose by 5.6 per cent in the twelve months to May, down from 6.8 per cent in April. Much of this improvement reflected volatile items, such as automotive fuel, but if we use the trimmed mean (as the RBA does) which removes the influence of outliers, then the annual increase fell from 6.5 per cent for the twelve months ending in March 2023 to 6.1 per cent for the year ending in May 2023.

Future monetary policy

But is this 4 percentage point increase in the RBAs cash rate enough, or is a further increase necessary? The truth is that we cannot be sure, but there are a number of considerations that suggest caution from here.

As the Governor, Philip Lowe, has repeatedly reminded us, the RBA faces a narrow path in threading its way between trying to bring inflation down without causing a recession and an unacceptable rise in unemployment.

A major consideration must be that monetary policy only operates with a lag. The increase in interest rates mainly has its impact by reducing the purchasing power of consumers and reducing the incentive to invest. But many loans were on a fixed interest rate, and it is only when these loans come due for review that the purchasing power of households is reduced.

The good news is that only about one third of households have a housing loan, but for those who do this review process for fixed rate loans has already started. However, the majority of fixed rate loan increases is still to come. The biggest number of such reviews will be in the next six months, with sizeable numbers into next year as well.

Thus, a household with a median outstanding mortgage of $600,000 will find that its weekly payments have increased by more than $300 per week once their interest rate is revised compared to just over a year ago. That represents a very large reduction in their purchasing power much greater than the gap between wages and other prices. And with the passage of time, this switch over to higher interest rates is now starting to bite and could become quite severe for an increasing number of households over the next year.

A second important consideration is that some of the key sources of increased inflation will not respond readily to higher interest rates. Energy costs have been a key driver of the recent surge in inflation, but Australian energy prices mainly reflect the prices in oversea markets, and that is not something that our monetary policy can influence. Instead, lower energy prices are better achieved by direct government intervention, such as the government has already taken to limit the cost of gas to electricity generators.

Similarly, and more recently rents have been a driver of inflation, but rents will continue to rise if the stock of housing is restricted, and that is what higher interest rates will do.

A wage-price spiral

I assume that the RBA is aware of these considerations, but its main concern now seems to be that it wants to head-off any compensating wage increases, at least over the next year or two. So the loss in real wages in the last couple of years will not be quickly recovered in the next year or two if we rely solely on the RBA to quickly bring inflation back within its target range.

The RBAs fear is that wage increases much above an annual 3 per cent risk setting off a wage-price spiral, in which case inflation will never come down, or at least not without a real recession.

But how realistic is this fear about a wages breakout? So far there is little sign of any such wages surge, and while unemployment is at record lows, there are signs that the demand for labour is weakening.

The most recent available data show that hourly wage rates increased by 3.8 per cent over the year ending in the March quarter. This is on the high side relative to the RBA target, but it is still much less than the inflation rate. Furthermore, the peak increases were back in the June and September quarters last year.

A major concern is the RBAs understanding (or lack of understanding) of labour markets. Between 2011 and 2019 the RBA persistently overestimated annual wage growth by about 1 percentage point as actual wage growth declined from about 4 per cent annually to around 2 per cent and only 1.4 per cent by 2020.

The RBA has tried to explain this sluggish wage growth by arguing that the rate of unemployment consistent with a low and stable inflation rate (the NAIRU) must have fallen from what the RBA thought was around 5 per cent to 4 per cent or even less. However, the RBA has never provided a proper explanation of what caused this fall in the NAIRU. Nor has the RBA considered the possibility that the response of wages to any change in unemployment may now be less than in the past.

But the institutional arrangements for the determination of wages today are very different from what existed at the time of the wage-price spiral back in the 1970s and into the 1980s. Today wages are no longer centrally determined, and wage contracts can extend over as much as three years, rather than only one year as applied back then. Indexation of wages to price increases is also no longer the norm.

In addition, although unemployment at 3.5 per cent is still at record lows, there are reasons to think that the pressure of demand in the labour market is no longer increasing.

As leading labour market economist, Prof. Jeff Borland, has recently shown:

Mid-2022 marked a transition in the Australian labour market. Employment growth in the preceding months had been enabled by drawing extra workers from unemployment and outside the labour force, as well as by population growth. But since mid-2022, flows from unemployment and a higher rate of labour force participation have made little contribution to employment growth. Instead, employment growth has come primarily from population growth.

Borland then concludes that:

employment growth is now eating into the number of vacancies and there has been a larger slow-down in the rate of growth in labour demand post mid-2022, than is evident from employment growth.

In other words, the supply of labour has caught up with demand, and the labour market is no longer tightening.

Finally, it is interesting that the central banks central bank, the Bank of International Settlements (BIS), has recently reported that for developed economies generally the feedback between wages and prices has been quite low in the last two decades, below 10%.

The BIS also found that over an extended period profits have grown while workers have gone backwards. BIS modelling, however, shows that if profits declined by 2.5% per year in 2023-24, inflation would return to its target zone while real wages would rise fast enough to make up for the recent loss of purchasing power.

Conclusion

In sum, the evidence surely shows that it is time for a pause in interest rate increases next Tuesday. The economy is slowing and inflation is coming down. While there are inevitably uncertainties, there is no solid evidence that a wage-price spiral is likely. Instead, the balance of risks is clearly in favour of the RBA pausing and waiting for more evidence before considering any further interest rate rises.