Talk to virtual Australian Business Economists briefing
For those of us who follow the macro economy, the figures we look at often throw up a puzzle: some part of the economy that’s not working the way we’ve come to expect it to. Often the puzzle eventually resolves itself – some relationship between two economic variables we expected to see just took longer than we were expecting to show up. Occasionally, however, we eventually realise there has been a lasting change in the in the structure of the economy – it now works differently to the way it did.
I think the big puzzle facing us at the moment is whether wages still work the way they used to. It’s this question that lies at heart of the stand-off between the financial markets and business economists and the Reserve Bank: inflation is clearly moving up out of the Reserve’s 2 to 3 per cent target, so why is the Reserve so hesitant to start fighting it by raising interest rates? The short explanation for this disagreement is that the markets are assuming wages respond to inflation pressure pretty much the same way they always have, whereas the Reserve has serious doubts about that.
Let me ask you a silly question: if some prices rise by large amounts, but the rise doesn’t lead to higher wages, is this “inflation” or just a once-off rise in the level of prices? I think to have “inflation pressure” and an “inflation problem” you must have a generalised rise in prices and rises that continue because they keep flowing through to wages as part of a wage-price spiral.
The Reserve is hesitating to tighten because it’s not yet convinced price rises are flowing through to wages. It wants to see more evidence that they are before it risks slowing the economy’s growth by raising interest rates. But there’s another reason it is hesitating: if the price rises we are seeing were the result of strong demand and the economy reaching full capacity, the case for tightening would be more pressing. But almost all the price rises we’ve seen, and expect to see in the next little while, are cause by problems on the supply side of the economy. They’re cause by pandemic bottlenecks, by the end of the drought leading to higher meat prices, floods leading to high fruit and vegetable prices and, of course, the invasion of Ukraine leading to higher oil and gas prices. And the trouble with raising interest rates is that the only thing they can do is dampen demand. What they can’t do is get supply back to working properly.
This is why the Reserve often choses to “look through” – ignore - a supply-side shock that causes a jump in a single price. Provided it doesn’t flow through to wages, it won’t be an inflationary problem. It will add to the level of prices, but not to the rate at which prices are continuing to rise. This reminds us of an important point: if the initial rise doesn’t flow through, the inflation rate will fall back unless there’s a further worsening in the supply-side problem that caused the initial rise. The complication at present, however, is that we haven’t had just a single supply-side shock but the coincidence of several shocks from quite different sources: the pandemic, extreme weather events and now the Ukraine war. When consumers see all that, they don’t see the economy having a lot of bad luck, all they see is a huge rise in the cost of living. And all they want is the usual solution to rising living costs: a pay rise.
The question is – the question we’re here to discuss – is whether all the people who’d like a big pay rise will get one. Until relatively recently, until about 2012, there was no reason to doubt that price rises led inexorably to wage rises. It was clear in all our history. Now, however, there’s much less reason to be confident that price rises simply flow through to wages. There’s plenty of reason to doubt that “wages still work the way they used to”. This is a lesson the Reserve (and Treasury) have learnt the hard way. For nine years in a row they confidently predicted that wages would continue growing strongly and for nine years in a row their forecasts proved far astray. GRAPH 1. Wage growth proved surprisingly weak and, not surprisingly, prices didn’t grow as strongly as they had been. For most of that time our inflation rate fell below the Reserve’s 2 to 3 per cent inflation target and stayed there. Something similar has been happening in the other advanced economies. In Australia, and as measured by the wage price index, wages are growing by just 2.3 per cent at present, and have grown by less than 2.5 per cent for seven years. As for real wages, in the six years before the pandemic, real wage growth averaged only 0.5 per cent a year, compared to past annual rates of about 1.5 per cent.
A related sign that something has changed in the way wages work comes from our experience with the NAIRU – the non-accelerating-inflation rate of unemployment, which is supposed to show the lowest the unemployment rate can fall before we start having problems with excessive wage growth and worsening inflation. In recent years we’ve seen the unemployment rate fall down to near or even below the point the model tells us is where the NAIRU stands without the least sign of strengthening wage growth. The way the Reserve and Treasury put it is that the relationship between wage growth and unemployment may have shifted. Other developed economies have had similar experiences, with estimates of the NAIRU being steadily lowered, as they have been here.
It's their fear that workers no longer have the ability to demand and receive decent pay rises – and their suspicion that, as a result, the NAIRU may be a lot lower that models based on past relationships are telling them – that has led Treasury and the Reserve to what I call Plan B: let’s drive unemployment as low as we possibly can, so that shortages of labour will get employers bidding against each other for the workers the need, and drive wages up that way. You can see this uncertainty on display in this year’s budget forecasts. Treasury says that the lowest it can get its model to say the NAIRU is is 4.25 per cent. But its forecasts are saying we can go for five years with an unemployment rate below the NAIRU and end up with inflation quickly falling back to the target range and staying there. Really? What this is really saying is that the authorities don’t believe the NAIRU is anything like as high as their model is telling them.
OK, now we get to the meat. If workers are no longer able to achieve wage rises much above 2 per cent a year, whereas rates of 3 per cent-plus used to be normal, why? What’s changed? There’s no shortage of potential explanations. First is the effect of globalisation, which has moved much of the world’s manufacturing to China and other low-wage countries. In Australia and other advances economies, the manufacturing unions used to set the pace for annual wage rises. Now, employers can always respond to wage demands by threatening to move overseas. And the information revolution is allowing many clerical activities – including call centres and data processing – to be moved offshore, thus reducing workers’ bargaining power.
Next, workers’ bargain power has been reduced by the decentralisation and deregulation of wage-fixing arrangements. Compulsory union-membership has disappeared. The right to strike has been greatly constrained. Unions have lost their right to enter employers’ premises and inspect the wage books. Union membership has fallen from over half in the 1980s to about 14 per cent today. The number of days lost through strikes has long been negligible. Our centralised wage-fixing system of old was meant to be replaced mainly by collective bargaining at the enterprise level, but both sides are agreed that enterprise bargaining is in decline. Big business says it has become inflexible and unworkable; the unions say some big employers are withdrawing from their agreements. About a quarter of workers now rely on the annual minimum wage case, which covers the whole range of minimum wage rates set out in awards. Most senior employees are covered by individual contracts. Unions argue that the increase in part-time, casual, labour-hire, contract and gig-economy jobs has increased the amount of “precarious” employment, weakened workers’ bargaining power and led to slower wage growth. But although casual observation makes this easy to believe, finding hard evidence of its growth in the labour force figures isn’t easy. Perhaps our ways of measurement haven’t kept up with changing employer practices.
The former top econocrat Dr Mike Keating argues strongly that technological change over the past 40 years has hollowed out the workforce in Australia and other advanced economies by automating many semi-skilled, routine jobs, while the number of highly skilled jobs has grown and the number of unskilled jobs has grown. GRAPH 2 The effect has been to make the distribution of earnings much more inequal. Because many of the jobs lost were highly unionised blue-collar jobs, this could help explain the workers’ overall loss of bargaining power and slower wage growth.
Professor David Peetz, of Griffith University, is among many labour economists who seek to explain outcomes in the labour market in terms of “monopsony” – not a single seller, but a single buyer. Or, at least, only a few big companies at a local level to whom workers can sell their labour. Just as product markets have become more concentrated, so have parts of the labour market for workers with particular skills. The smaller the number of firms, the easier for them to limit employees’ bargaining power by reaching no-poaching agreements between themselves, or requiring employees to sign non-disclosure agreements or non-compete clauses. All these restraints are much easier to impose when there are no unions to argue with.
Against all this, the Reserve and Treasury say that, the proportion of people moving jobs has risen in recent times, and that those who move go to jobs with wages 8 to 10 per cent higher. Some employers are trying to attract or retain staff by paying one-off bonuses, or by promoting workers to a higher grade. That’s all very interesting, but it’s hard to know how much it adds up to at a macro level. Treasury says the wage price index is a narrow measure of wage growth and more inclusive measures, such as the national accounts measure of average earnings, AENA, shows hourly wages grew by 3.5 per cent over the year to December.
I’ve given you the evidence suggesting that wages don’t work the way they used to and I’ve given you a smorgasbord of possible explanations of why and how the labour market has changed. Now we can sit back and see how much trouble the econocrats have in coming months keeping inflation under control without overdoing it. I hope this will leave us with a much better feel for the relationships between prices, wages and unemployment.
