This time last year, a common catchphrase used in economic commentary was “uncharted territory”. And fair enough too, given the global lockdowns, the mass experiment of millions of people working from home and the frightening images of field hospitals being erected overseas.
Fast forward 12 months, and the Australian economy is in far better shape than feared, with Prime Minister Scott Morrison keen to point out all the jobs lost to COVID-19 have been regained.
But there are still many parts of the economic outlook that are highly uncertain, and perhaps the most important of these is what’s happening with wage growth.
How wages evolve will be perhaps the most important influence on the RBA’s policies of priming the economy with ultra-cheap debt, and the potential that creates for asset bubbles.
This week produced further evidence Australia’s recovery is on track, with unemployment falling from 6.3 per cent to 5.8 per cent in February. The result smashed market expectations and is unequivocally good news.
Yet according to the latest public estimates of the RBA — which admittedly predate those statistics — we are probably three years away from interest rates edging up from their record low of 0.1 per cent. Why the big delay between today’s recovery and future rate rises?
The explanation reveals important shifts in what is driving interest rates both here and overseas, and changes in how economists see “full employment.”
Recently, however, pay packets have expanded at a miserable pace, with the most recent figures showing annual wage growth of just 1.4 per cent. That’s a far cry from the 3 per cent growth that RBA governor Philip Lowe thinks will be needed to get inflation in the target range.
So, how does Lowe plan to engineer a more-than-doubling in the pace of wage growth?
By getting the labour market to a point where it is so “tight” that competition for staff drives employers to start handing out bigger pay rises.
This is based on the idea that unemployment and wage growth have an inverse relationship. As unemployment gets lower and more people who want jobs are employed, it creates skills shortages, driving up the cost of labour.
It makes a lot of sense in theory. But in the real world, the RBA and other central banks struggled to pull off this balancing act even before the huge shock of the pandemic. More fundamentally, no one knows precisely how far unemployment needs to fall before wages start to meaningfully rise.
In the past, it was thought the “non-accelerating rate of unemployment”, or NAIRU, was about 5 per cent, which economists regarded as akin to “full employment”.
But today, most economists think the NAIRU is much lower, due to a host of deep-seated forces that have held back pay rises, including higher competition through the “offshoring” of work, labour-replacing technology and workers losing bargaining power with bosses.
No one knows exactly where the NAIRU is, but economists think it could be about 4 per cent, or possibly lower.
If they’re right, there is a long way to go before our labour market is even close to being tight enough to drive much bigger wage increases.
National Australia Bank economist Tapas Strickland this week gave a powerful illustration of how far unemployment may need to come down to get wages back up, saying the last time our unemployment rate was in the 3s was the 1970s.
In the United States, unemployment fell to just 3.5 per cent before the pandemic, which was the lowest level since 1969. Yet inflation was still pretty soft, and wage growth only started to lift.
ANZ Bank economists have recently forecast that even if unemployment gets back to 5 per cent, it would still only lead to wage rises of 2 per cent by the end of 2022.
Closer to home, unemployment in NSW fell to just 4 per cent in early 2019, without lighting any inflationary fires.
And before unemployment can get anywhere near those levels, the labour market still has to navigate the withdrawal of the JobKeeper scheme at the end of this month, which could well result in more people losing their jobs.
Even if the end of JobKeeper goes relatively smoothly, it still takes a long time for a tight labour market to translate into bigger pay rises, partly because collective agreements typically get re-negotiated every few years.
ANZ Bank economists have recently forecast that, even if unemployment gets back to 5 per cent, it would still only lead to wage rises of 2 per cent by the end of 2022.
So it’s safe to assume unemployment is probably going to have to be kept much lower for longer than has been the case for years.
What’s more, this isn’t the only reason that the RBA is likely to keep rates at such extraordinarily low levels. The other, related shift is that the RBA has subtly changed the hurdle for eventually raising interest rates from these ultra-low levels.
In the past the RBA would move interest rates in response to its forecasts for inflation, but now it is putting more weight on the actual level of inflation in the economy.
As explained by NAB’s Strickland this is reflected in a subtle shift in the language used by central bankers, who now talk about the “maximum possible sustainable employment,” rather than hiking rates in response to a pre-conceived idea of the NAIRU.
As Lowe has put it, it’s likely that “wages growth will need to be sustainably above 3 per cent” for inflation to be within the RBA’s target.
No one really knows how long it will take to get wages growth to the much quicker pace Lowe is aiming for. But until it’s achieved, which will probably take years, don’t expect interest rates to change.
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