The Reserve Bank is widely expected to increase interest rates further. However, what is now critical to achieving the Bank’s inflation target is the future increase in labour costs, and this may come down sufficiently without any further interest rate rises.
The inflation outlook and interest rates
As has been widely reported, interest rates have increased fast and furiously in response to the increase in inflation. Since May last year the Reserve Bank (RBA) has increased its cash rate 13 times, from a low of 0.1 per cent to 4.35 per cent this month.
The good news is that the latest OECD assessment of the Australian economy stated that although inflation is still high, it has peaked and the “one-year-ahead inflation expectations of consumers and union officials have eased”. Accordingly, the latest OECD forecasts assume that the RBA’s cash rate will not be increased further, and after a period of stability until it is clear that inflation is declining, there will be 75 basis points of interest rate cuts between the third quarter of 2024 and end-2025.
But the decisions that matter will be made by the RBA, and that OECD assessment would have been written before a speech last week by the new RBA Governor, Michele Bullock. That speech was interpreted by financial markets as indicating that interest rates have not yet peaked, and it is most likely that another two interest rate rises can be expected in coming months.
The RBA remains concerned that while inflation is coming down that deceleration is likely to be slower than previously expected, and slower than desired. In particular, the Governor pointed to the fact that “the remaining inflation challenge … is increasingly homegrown and demand driven”.
To support this conclusion, the Governor cited three pieces of evidence:
1. Inflation is broadly based, with around two-thirds of the items measured in the CPI increasing above 3 per cent;
2. Inflation is increasingly underpinned by services, and as these are not imported, these increases must reflect domestic economic conditions;
3. The increased cost of services is typically driven by domestic labour costs, which have been exacerbated by weak productivity growth.
In short, what matters most for the inflation outlook, and consequently interest rates, is how fast future labour costs can be expected to rise.
The wages outlook
The RBA considers that there is still only limited spare capacity in the economy, as is “most evident in high rates of labour utilisation”.
Nevertheless, the RBA has been wrong in the past about how tight the labour market is and the consequences for wages growth. For most of the pre-Covid decade, the RBA considered that the rate of unemployment consistent with achieving their inflation target (the NAIRU) was a bit above 5 per cent. But over this same period the RBA’s forecasts for wages growth were consistently too high, and eventually the RBA acknowledged that the NAIRU was lower than the 5 per cent figure that the RBA had been using.
Therefore, even though the latest unemployment rate is 3.7 per cent and only slightly above the minimum achieved of 3.5 per cent, we cannot be sure just how tight the labour market presently is.
Furthermore, as one of Australia’s leading labour market economists, Prof. Jeff Borland, recently concluded in his latest Labour Market Snapshot: “At this stage, nominal wage growth itself does not seem an impediment to bringing down price inflation”.
In support of this conclusion Borland found that:
- Enterprise agreements, covering about 35 per cent of employees, are not reflecting in any major way higher price inflation, with rates of wage increase in new EBAs lodged in 2023 being flat or trending down, and less than 5 per cent of these EBA’s had future wage increases linked to the CPI.
• Individual wage agreements, covering about 40 per cent of employees, are also not driving wage growth, with no significant association between the wage growth in individual industries and the proportion of employees covered by individual agreements.
Instead, Borland argues that it is only the remaining 20 per cent of employees who are covered by awards whose wages have been adjusted in response to inflation. But even for these employees, their wage growth has been reactive, with wage growth following rather than anticipating higher inflation.
In sum, Borland concludes that “thus far wage growth ‘per se’ does not seem an impediment to bringing down price inflation.” Borland therefore considers that “The labour market is currently operating below the rate of labour underutilisation that represents full employment.”
Instead, Borland suggests that “what may be an impediment [to lower inflation] is low productivity growth.”
In the last financial year, 2022-23, labour productivity (as measured by GDP per hour worked) fell by 3.7 per cent. A fall of this size is almost unprecedented, but equally important is that productivity only fell in this one year. In the three preceding years, labour productivity increased by an average of 1½ per cent. Furthermore, this was better than the average annual growth rate of 1.1 per cent achieved over the previous nine years between 2009-10 and 2018-19.
Thus, there is some reason to hope that productivity growth might return to its long-term average growth rate, except for the fall last year in 2022-23. But that underlines the importance of obtaining a better understanding of why productivity fell by such an unprecedented amount last year.
Borland finds that about one fifth of the fall in productivity in 2022-23 was driven by a shift in the industry composition of employment towards lower productivity industries. By contrast, previous years had mainly seen compositional shift in employment towards higher productivity industries.
But that still means that four fifths of the exceptional fall in labour productivity in 2022-23 was due to lower productivity within industries. Borland finds no evidence that declining average skills are a reason for this negative productivity growth. Similarly, the industry evidence does not suggest that working from home helped cause the fall in productivity growth in 2022-23.
Instead, when comparing different industries, Borland finds a negative correlation between growth in hours worked/average hours worked and labour productivity. This finding suggests short-term workforce adjustment problems are a major reason for the fall in productivity in 2022-23. In that case, however, these problems may not last, and wage driven inflation will not be much of a future problem.
Finally, it is interesting to note that while the rate of increase in wages and the increase in average labour cost per hour are usually about the same, this was not true most recently in 2022-23. That year the increase in the average labour cost per hour was only 2.8 per cent while the increase in wages (as measured by the wage price index) was as much as 3.6 per cent.
However, it is the average labour cost that matters for businesses when setting their prices, and if this only increased by 2.8 per cent that further suggests that inflation will come down.
In sum, as Borland suggests, although we are “still a long way from understanding everything about the [recent] decline [in productivity]”, there is some reason to think that most of the problem is a short-term adjustment problem. In that case, it would pay to be cautious about the probability that excessive labour costs will prevent inflation coming back down within the target range without further interest rate increases.
Obviously the proof of the pudding regarding future inflation will be what the future data tell us as they are released.
The consumer price (CPI) data for the December quarter will be released just before the meeting of the RBA next February. No doubt that reported increase in the CPI will heavily influence the RBA Board decision about whether to increase interest rates further.
But as argued above it is quite likely that there will be no significant acceleration in the rate of wage increases. Accordingly, there is good reason for caution before any further increase in interest rates.