The RBA just set out some challenges with an obscure economic threshold that can influence interest rates

Credit: Microsoft

Spare capacity in the labour market is an important input into forecasts of inflation, wage growth and eventually monetary policy.

It’s basically a measure of the gap between the work being currently done in the economy, and what could be done if the available workforce was fully engaged.

In the Australian labour market, the spare capacity has declined since the mid 1990s from 7% to about 5%, according to the RBA’s bulletin. However, the central bank says the model used to measure the rate is noisy, and can easily overstate or understate the slack.

The RBA instead focuses on labour underutilisation and a relatively obscure measure in economics called the NAIRU – or non-accelerating inflation rate of unemployment.

This is the level of unemployment at which, broadly speaking, inflation would be expected to start rising noticeably, as wages rise and pricing power for both workers and companies starts flowing through the economy.

The following paragraph from the RBA’s bulletin, out today, explains:

Estimates of the NAIRU are uncertain because it cannot be observed and the data provide only a noisy signal. The current estimate of the NAIRU is 5% of the labour force, with a 70% confidence interval of plus or minus 1 percentage point. This means that, even if the models of inflation and wage growth are right, there is still a 30% chance that the ‘true’ unobserved NAIRU is either higher than 6% per cent or lower than 4%. Given the March quarter unemployment rate of 5.75%t, the model suggests an 80% chance that the unemployment rate is above the NAIRU.

The high degree of uncertainty around the NAIRU estimates means new data can change the estimate for the previous few years. Each series shows the estimate based on the data up to that time period.

For example, the estimates made using data up to the December quarter of 2015 showed the NAIRU had been fairly flat over the previous two years and was around 5.2%. But by the March quarter of 2017, the latest estimates show the rate had been falling over that same period and was 5.0% in the March quarter of 2015, the RBA said.

Between 2004 and 2014, the underemployment rate tended to move fairly closely with the unemployment rate. This meant the unemployment rate was a reasonable proxy for any effect that changes in the underemployment rate had on wage growth.

Over the past few years, however, the underemployment rate has been relatively stable while the unemployment rate has declined. Any effect of the underemployment rate on wage growth – over and above the effect of the unemployment rate – would result in lower wage growth than expected by the model. This would then cause the model’s estimate of the NAIRU to decline.

This explanation implies that the unemployment gap, as measured using the unemployment rate, is currently understating the degree of spare capacity in the labour market.

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