Why weak inflation is not necessarily a good thing for Australian workers

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Australian labour market conditions are the strongest they’ve been in many years.

Employment growth has surged over the past year, with most of those jobs full-time positions, while the national unemployment rate now stands at the lowest level since February 2013.

And with leading labour market indicators also strengthening, it suggests the recent trend will likely continue in the months ahead.

It’s been a stellar turnaround to what was seen throughout most of last year.

However, while the labour market is clearly strengthening, the one question that remains unanswered is whether it will lead to a meaningful pick-up in wage pressures, eventually paving the way for the Reserve Bank of Australia (RBA) to lift interest rates for the first time since late 2010.

Some, such as the National Australia Bank, think it will. Others, like Westpac, don’t.

In theory, tighter labour market conditions, as we’re witnessing in Australia right now, should lead to a pick-up in wage pressures as strong demand for labour mops up excess supply, eventually creating the conditions where worker shortages occur.

Unemployment is starting to decline, even with strong levels of population growth and more Australians either finding or looking for work. The rate is currently 5.5% and moving towards the sub-5% levels that are generally associated with full employment.

In theory, the prospects for wage increases are improving.

However, as has been seen in many other major developed nations recently where unemployment levels are far lower than Australia, tighter labour market conditions don’t necessarily guarantee that an acceleration in wage growth will occur.

And, based on the evidence in the chart below, it suggests that wage pressures in Australia remain close to non-existent.

Source: UBS

From UBS, it overlays average annual pay increases for new Australian Enterprise Bargaining Agreements (EBA) against changes in Australia’s Wage Price Index, a quarterly measure of average hourly wage rates for workers.

An EBA is a registered agreement that sets out the terms and conditions of employment between an employee or group of employees and one or more employers, according to the government’s Fair Work website.

George Tharenou and Carlos Cacho, economists at UBS, say EBAs remain a key lead indicator of economy-wide wages because they are the main form of collective agreement covering 36% of Australian employees.

And the news from the June quarter was not good for anyone hoping that stronger labour market conditions would lead to a pick-up in wage pressures.

“New EBA’s struck in Q2-17 showed a disappointing further fall to a new record low of 2.6% annual rate, well down from the prior trend of 3-3.5%,” say Tharenou and Cacho.

“Indeed, even construction, which remains the strongest industry, dropped back to a 24-year low of 3.7%.”

So even in the sectors where labour market conditions are strong — such as construction — wage increases in newly-struck EBAs are continuing to fall compared to levels seen in previous agreements.

That trend is captured perfectly in the next chart, also from UBS, showing the annual pay rates for new EBAs compared to those currently in place.

Source: UBS

“Given that EBAs have an average duration of 3 years, as existing EBAs expire in coming years they are still being replaced with new agreements at much lower wage rates,” UBS says.

“Unless new EBAs suddenly reverse this downtrend in coming quarters — outside of the minimum wage decision impact on other awards — EBAs are likely to remain a cap on overall underlying wage pressure ahead.”

Australia’s minimum wage rate was recently increased by 3.3% at the start of the September quarter, providing a temporary one-off boost to some Australian workers.

However, any benefit from that increase may well be overridden by continued weakness in inflationary pressures with recent estimates from the RBA suggesting that around half of EBAs are now either directly linked to consumer price inflation (CPI), or use CPI as the primary driver of wage increases.

Tharenou and Cacho says that presents a headwind for upcoming EBA pay rates given headline CPI fell to just 1.8% in the September quarter of this year.

“[This] reinforces our view the future rise in wages will disappoint the hawks, despite booming jobs growth and a modestly declining trend in the unemployment rate,” they say.

“We continue to expect a more modest and benign outlook for wages and CPI than most, including the RBA.”

Analysis from UBS suggests less than 40% of workers on EBAs are now receiving pay increases above the RBA’s 2-3% inflation target, half the level seen just five years ago.

Despite the headwinds facing new EBA wage agreements from persistently low inflationary pressures, UBS still expects the RBA will lift interest rates by 25 basis points to 1.75% in the second half of 2018.

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