The RBA's Ace in the Hole

When RBA Governor Philip Lowe made a speech at the AFR summit in March, he mentioned it was positive that wages growth remained consistent with the inflation target. Dr Lowe has previously explained that wages growth of 3.5% p.a. would be consistent with the desired inflation outcome of 2.5% p.a., the difference being explained by expectations for productivity growth of around 1% p.a. Wages can sustainably grow faster than consumption prices if the workforce can produce more output per dollar of compensation paid, a measure related to a concept of unit labour cost (ULC). However, if those modest productivity gains are not realized, even a 3.5% p.a. wage inflation rate may be too high.

The following chart shows the relationship between the quarterly rate of growth of trimmed mean inflation (blue bars) and nominal ULC (white line). Generally, low inflation is associated with low ULC and both are unsustainably high at present:

In yesterday’s release, following the RBA decision to raise rates, ULC was observed to be rising briskly owing to subdued productivity growth. Part of the reason this may be occurring is because the level of competition amongst firms is declining and this has weakened incentives to improve and grow. This is inferred from longer-term data which shows fewer new firms opening and workers becoming less likely to change jobs, contributing to an increasingly sluggish reallocation of resources away from low-productivity activities. The economy is becoming less dynamic.

Should productivity not recover to pre-covid levels soon, economic growth will tend to be lower and inflation will likely be higher than presently anticipated. This will challenge the RBA’s desire to keep the economy on an even keel as inflation is managed downwards. They will need to create more slack in the labor market to bring wages into closer alignment with the targeted inflation rate.

Lowe’s speech in March included an ad-lib phrase “and that’s an important proviso”, when discussing the need for productivity growth to revert to its pre-pandemic pace in order for current wage growth to be consistent with the inflation target. This phrase was curiously omitted in the official text. That doesn’t change the fact that it really is an important proviso that is presently contributing to upside risk to the rate path and bears close scrutiny. The RBA has now brought this risk explicitly into the frame in its latest release and could readily draw upon this to justify another hike from here.