- Australian economic growth is strong and unemployment sits at a six-year low. However, inflationary pressures remain close to non-existent, keeping the RBA on the sidelines.
- Economists at the Commonwealth Bank say weak wage growth is to blame.
- It says the main factor behind weak wage growth is a high proportion of underutilised workers, exacerbated by Australia’s high immigration intake.
However, despite signs that stronger economic growth is helping to reduce excess capacity in the Australian economy, inflationary pressures still remain close to non-existent.
According to the Australian Bureau of Statistics (ABS), consumer price inflation grew by just 2.1% in the year to June, a result largely reflecting a one-off boost provided by higher fuel prices.
Underlying inflation, of more importance to the Reserve Bank of Australia (RBA) when it comes to monetary policy deliberations, was even weaker, growing by just 1.9% over the same period, leaving it below the bank’s 2-3% inflation target.
Economic growth is strong and unemployment is falling — something that should act to boost inflationary pressures.
However, it isn’t. But why?
According to Gareth Aird, Senior Economist at the Commonwealth Bank, the missing piece of the inflation jigsaw puzzle is ongoing weakness in Australian wage growth.
“Wages growth remains weak in Australia,” he says.
“As a result, consumer inflation is low and the RBA’s policy rate has been anchored at 1.5% for the past two years.
“Over that period of time, the labour market has tightened but, unfortunately for workers, wages growth has been stuck at around 2%.”
According to the ABS Wage Price Index (WPI) released earlier this month, average hourly earnings, excluding bonuses, grew by 2.1% in the year to June, unchanged from the level reported in the March quarter.
Public sector wages grew by 2.41% over the year, significantly faster than their compatriots in the private sector who saw wages grew by a paltry 1.99%, below the pace of inflation.
That means for a majority of the Australian workforce, average wage growth went backwards over the past year.
As seen in the chart below from the Commonwealth Bank, annual growth in the WPI still remains well below the levels seen either side of the GFC, even with a stronger economy and lower unemployment.
While there has been ample debate about what has led to recent weak wage outcomes, including from the RBA, Aird says there are three primary factors that help explain why wage growth remains so low.
“There are a few reasons for this, but the primary one is that there is plenty of spare capacity in the labour market which reduces the ability of employees to negotiate pay rises,’ he says.
“In addition, inflation expectations have adjusted downwards which weighs on nominal wages growth. At the same time, low productivity has weighed on real wages growth.”
In particular, Aird says its the first two factors — elevated levels of labour market underutilisation, including both unemployed and underemployed workers, as well as declining inflation expectations — that largely explains why real wage growth for a majority of Australian workers is going backwards, creating a model that uses both that correlates strongly to annual movements in Australia’s WPI.
“The model explains trends in wages growth very well,” he says.
“That is, it supports our claims that most of the weakness in wages growth can be explained by the level of spare capacity in the labour market and changes in inflation expectations.”
The first factor, in particular, is an interesting one with spare capacity in the labour market still elevated even with employment growing at the fastest pace on record for a calendar year in 2017.
As opposed to other economists who believe unemployment is the best single measure of slack within the Australian economy, Aird says it’s the underulisation rate that has a far stronger relationship to changes in wage inflation.
“Changes in the unemployment rate alone are no longer a sufficient proxy for changes in labour market slack,” he says.
“To capture total labour market slack we can use the sum of the unemployment rate and the underemployment rate which produces the underutilisation rate. It currently sits at 14%, close to its highest point since the late 1990s.
“This means that there is a significant proportion of the population looking for work in some capacity.”
Pointing to the chart below, Aird says there is a close inverse relationship between underutilisation and wages growth.
As underutilisation rises, wages growth falls, [and vice versus],” he says.
“The fitted line implies that for an underutilisation rate of 14%, wages growth, as measured by the WPI, should be around 2.5% per annum.
“In other words, most, but not all, of the current weakness in wages growth can be explained by a high level of labour market underutilisation.”
So why is such a large proportion of the workforce either unemployed or employed but looking to work more hours? Employment growth, after all, was the highest level on record last year.
Aird says the answer is simple: while demand for labour has been strong, so too has been the supply of workers.
“Slack in the labour market is elevated in Australia because the supply of labour has exceeded the demand for workers. Policy has played a role,” he says.
“The decision to run a very high immigration program by OECD standards has augmented the supply of labour and pushed up the participation rate beyond what would have naturally occurred. That intensifies the competition for existing jobs while also adding to the demand for labour.”
He says recent evidence suggests that running a high immigration program, at a time when there is already high levels of labour market underutilisation, has meant that skill shortages have “not able to manifest themselves as quickly as they might have otherwise because employees are able to hire from abroad in sizeable quantities.
“The relatively high intake of skilled workers looks to be a pre-emptive strike on the expectation that there will be skills shortages in the future,” he says.
“If there was widespread skills shortages then wages growth would be higher than its current rate of 2.1% per annum.”
Based on latest data released by the ABS, Australia’s estimated resident population rose by 388,000, or 1.6%, in 2017. Net overseas migration accounted for 62% of the increase.
Along with weak productivity growth, something Aird says explains recent weakness in real wage growth, and a larger proportion of Australian firms expecting inflation to average 3% or lower in the future compared to periods of the past, it helps explain why pay growth is showing few signs of accelerating, even with the help of unusually large increases in Australia’s minimum wage rate over the past two years.
Aird expects that trend will continue for some time yet, likely ensuring that the official cash rate from the RBA will remain unchanged for at least another year.
“The future path of nominal wages growth in Australia will be dependent primarily on the level of labour market slack, but also on inflation expectations,” he says.
“Inflation expectations remain anchored in Australia while labour market slack, as measured by the underutilisation rate, is coming down ever so gradually.
“This suggests to us that wages growth should lift a little from here, but that the process is likely to take time.”
Aird says that when the WPI lifts at an annual rate of 2.5% per annum, it will likely mark the point when the RBA will begin to lift official interest rates.
“We see that happening in late-2019 and have the RBA lifting the policy rate to 1.75%,” he says.
“From there, an incredibly mild tightening cycle looks probable as wages growth edges higher.
“We see the RBA moving by 25 basis points at six-month intervals before stopping at 2.5%.”
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