Be it interest rates, wage growth or core inflation, all sit at record lows in Australia at present, an oddity to some given the perceived strength of the economy, at least compared to other developed nations in recent years.
The Australian dollar has fallen, as too has unemployment, and yet inflationary pressures remain close to non-existent, culminating late last month when the Australian Bureau of Statistics’ core consumer price inflation rate slumped to a record-low annual rate of just 1.55%.
To Gareth Aird, senior economist at the Commonwealth Bank (CBA), there’s an easy explanation as to why disinflation, rather than inflation, is prevalent right now: elevated levels of labour market slack, or simply that there’s been more workers than work to do in the Australian economy.
“While GDP growth in Australia has been solid, if not spectacular, domestic demand growth has been soft. And while the unemployment rate has trended down recently, it is still stuck above the level associated with full employment,” says Aird.
“In other words, there is slack in the Australian economy and this has led to record low wages growth and underlying inflation now running below the RBA’s 2-3%pa target band.”
As in any market, prices in the labour market, wages in this case, are subject to the forces of supply and demand. When there’s more demand than supply wage growth tends to increase, as experienced by many in the pre-GFC period where strong economic growth and limited supply of available workers pushed wage inflation to levels not seen in many decades.
Now, the opposite is occurring. There’s more supply of labour than demand, and as a result wage pressures are falling.
While unemployment is falling, something that should help to lift wage pressures, Aird notes that other labour market indicators suggest there’s significantly more slack in the labour market at present, hindering economic growth.
The unemployment rate that is commensurate with an economy producing around its potential output is generally associated with stable inflation. It is referred to as the ‘non-accelerating inflation rate of unemployment’ (NAIRU). The most recent OECD estimates of the NAIRU in Australia put it at 5.3% and Treasury estimates it to be 5.0%. Whichever way you slice it, the unemployment rate in Australia has been above the NAIRU for the past three years even though it is low by historic standards.
The underemployment rate, however, remains near its highest level on record. This indicates that the Australian economy is operating below its capacity and an output gap has opened up.
The output gap that Aird refers to is simply the difference between the output of the Australian economy compared to its maximum potential output, or full capacity.
In this instance, Australia’s output gap is negative, indicating that the economy is operating below its potential capacity.
“The underemployment rate tends to fly under the radar, but it’s a very usual measure of labour market slack,” says Aird.
“It provides a gauge of the proportion of people who are employed people but whose labour is not fully utilised. It is near its highest level on record. The sum of the unemployment rate and the underemployment rate produces the underutilisation rate which is the broadest measure of spare capacity in the labour market – it is high and presently sits above the level hit during the Global Financial Crisis.”
The chart below, supplied by CBA, reveals the elevated level of underemployment and underutilisation in Australia at present. Unemployment may be falling, but broader measures of spare capacity in the labour market remain above levels seen during the GFC.
To Aird, this, along with with muted tradable inflation — that determined by offshore factors — has led to the slowdown in wage growth and inflation.
“The impact of declining wages growth as a result of a lift in spare capacity has put downward pressure on non-tradables (domestic) inflation. At the same time, tradables inflation has slowed primarily because of a big fall in the price of oil. This muted the impact that the lower AUD was expected to have on tradables inflation,” suggests Aird.
“As spare capacity in the labour market has lifted, wages growth has slowed and dragged down the rate of domestic inflation with it.”
Unfortunately for those expecting a hefty wage increase, Aird believes that spare capacity in the labour market will likely persist, keeping a lid on wage costs. He even suggests that weak inflation expectations among Australian businesses could see wage growth slow even further, as suggested in the chart below.
However, all is not lost, particularly if you’re a borrower. As a result of these weak inflationary pressures, Aird believes that further rate cuts are coming.
“We expect further monetary policy easing and have pencilled in two more rate cuts that would take the cash rate to just 1.25%,” he says.
“As always, the timing of picking rate moves is pretty tough. But we favour August and November as these dates follow CPI updates. In our view, all rate meetings over the near term are ‘live’ and activity data will play a role in shaping market expectations and pricing over coming months.”