21 November 2023

Does the Reserve Bank’s ‘narrow pathway’ to a soft landing exist?

The Reserve Bank is trying to achieve something extraordinarily ambitious. It is hoping, and forecasting, to bring inflation down from a multi-decade high last year to the 2 per cent-3 per cent target range – while maintaining close to full employment.

However, a look at history tells us this is not how things have worked out in the past. The key statistical relationship that forms much of the basis of inflation-targeting regimes, the Phillips curve, suggests some scepticism may be warranted.

The Phillips curve shows inflation typically rises when the jobless rate falls (and vice versa). In addition, once the unemployment rate is below a certain threshold, labour is typically in such short supply that wages rise and, in a fully employed economy, companies are then able to pass on these costs via higher prices, keeping inflation elevated.

When inflation has come down in previous cycles, the jobless rate has risen. Just before the global financial crisis in 2008, when core inflation had peaked at 4.8 per cent, the subsequent 2.6 percentage points of disinflation occurred as the jobless rate rose 1.8 percentage points. In the early 1990s, 4.7 percentage points of disinflation happened alongside a 5.3 percentage point rise in the unemployment rate.

By comparison, the RBA is forecasting that underlying inflation, which peaked at 6.8 per cent last year, will fall 3.9 percentage points by late 2025, back to its target, but that the unemployment rate will only rise 0.9 of a percentage point. This would be a very soft landing.

Why might this time be different?

Part of the answer is that much of the sharp rise in inflation was driven by the pandemic and Ukraine-war-related disruptions to supply that forced up the prices of manufactured goods, shipping, oil and food, and that as these effects wear off, inflation should fall. The problem with this explanation is that these disruptions have now largely passed, but Australia’s inflation is still well above target.

Another possibility is that the now reopened border helps to deliver sufficient labour supply and that this puts enough downward pressure on wage growth and inflation to get it back to target.

Discouraging productivity measure

The challenge here is that although many more migrants are arriving, in turn helping to deal with skills shortages, this is also boosting aggregate demand, particularly for housing, which itself adds to inflation.

Another reason why this time might be different would be if the supply side of the economy has become more flexible. It would be much more painless to bring inflation down by boosting supply, rather than through a sharp weakening in demand and the widespread job lay-offs this would probably entail. Here the evidence is not particularly supportive of the RBA’s soft-landing forecasts.

First, the measured productivity of the existing workforce has been discouraging recently. After rising about 1 per cent a year in the decade to 2019, it has fallen 2.7 per cent since the start of 2020.

Some of this may reflect behavioural changes associated with the pandemic. For example, it may be that an increase in working from home has weighed on productivity rather than boosted it. It could be that at very low levels of unemployment, the skills of the most recently hired workers do not match the jobs they have been hired for very well. It could also reflect measurement issues with productivity, although the magnitude of the decline suggests some part of the fall is almost certainly genuine.

Second, if the supply side is to be more flexible, improvements in industrial relations, the tax system and competition would all help. However, in none of these areas is there much evidence that the supply side of the economy will become more flexible in the near term.

On a positive note, there is recognition of the need for fiscal policy to play a role in lowering inflation.

This year’s federal budget saw the government run a budget surplus and save most of the upside surprise to its revenues, although saving all of it would perhaps have been an even better option.

However, state budgets have been far less helpful, with many still running large deficits. The federal government is now putting some pressure on the states to tighten up, including plans to trim infrastructure spending, but more tightening is likely to be needed.

The Phillips curve trade-off is not set in stone, and maybe this time is different. However, history and the current structural policy environment caution against assuming this.

At minimum, this suggests rate cuts are unlikely anytime soon and rates may have to be higher for longer. At worst, Australia may have to endure a much larger rise in the unemployment rate to get inflation to come down.

Former RBA governor Phil Lowe described the soft-landing scenario as a “narrow pathway”, presumably to highlight that it might be possible, but that a lot of things would have to go right. Does this narrow pathway actually exist? Time will tell.

This article first appeared in the Australian Financial Review on 21 November 2023.