Fix low productivity or get used to high inflation for longer

This makes it difficult for casual observers to keep track and changes the nature of what policymakers ought to be doing.

Let me explain. Although growth has slowed and demand has weakened, largely because of the rise in interest rates, the economy is still operating beyond its sustainable capacity, which means inflation is still too high. This is because its supply side is very weak too.

What is the reason for this? We think this largely reflects the still-reverberating delayed effects of the policy response to the COVID-19 pandemic. It also demonstrates a lack of policy focus on improving productivity.

In short, the rhythm of the current cycle is different.

In typical cycles, inflation picks up, interest rates rise, the economy slows, inflation falls and the central bank starts cutting rates. Often, this is seen most vividly in the housing cycle. Rate increases typically lead to a fall in house prices and rate cuts drive them higher again.

Many observers wonder why interest rates are not coming down.

Indeed, the rate cuts still seem to be some time away in Australia and the central bank is actively talking about the possibility of lifting its cash rate again.

One way to observe the balance of supply and demand is by looking at surveys of capacity utilisation. These show that although capacity utilisation has fallen from the record highs and excessive rates of 2022 and 2023, it is still at high levels relative to history.

Another way to see this is in the unemployment rate. Although it has risen from its 50-year low of 3.5 per cent struck in late 2022, the current rate of 4.2 per cent is still at the lowest level it has been in all but two of the past 50 years.

One solution to the problem of high inflation and a still stretched economy could have been more aggressive RBA rate increases. This might have helped bring inflation down faster, but the cost would have been a steeper economic downturn or a recession. This happened in New Zealand.

A better solution would have been to take clear action that would help lift productivity. Unfortunately, Australia has had the worst productivity performance of any comparable developed economy in the post-pandemic period.

The second quarter GDP figures, released recently, suggest that GDP per hour worked, a key measure of labour productivity, is no higher than it was in 2016.

The list of policy measures that could be taken to improve productivity is long. A short one would include making the labour market more flexible through industrial relations reforms, removing unnecessary regulation, reforming the tax system, and a broad-based focus on improving competition.

The current state of the economy, with capacity as stretched as it is, is very unusual by historical standards. Only one episode looks similar – between 2006 and 2008 when the mining boom pushed the economy beyond its limits and inflation picked up.

That problem was resolved by the global financial crisis of 2008, which sent a shock wave through the economy, markedly weakening demand, increasing spare capacity, and lowering inflation and interest rates.

For much of the rest of the past 40 years, the economy has operated with spare capacity and the primary challenge for policymakers has been getting demand to grow faster.

This partly explains why the current state of the economy is so difficult to understand and why the nature of optimal policy has changed.

Throughout most of recent history, policymakers have celebrated initiatives that boost demand and create jobs. “Ribbon-cutting” events or “shovel-ready” projects are typically very popular.

But such actions are not the right ones at the moment. We need to boost supply and productivity, not demand. If there are more jobs created by expansionary policy measures, the key question is: who is going to fill them?

Even this task is difficult because the immediate source of new workers is from overseas. But these same migrants that add to the workforce and help boost supply also add to demand in the economy and inflation.

The current state of the economy involves an entire shift in the mindset of what it means to set economic policy.

It is also a poignant reminder of how important it is to focus on lifting productivity. For many years, economists, including myself, have written avidly about the need to lift productivity to raise living standards.

But there is now another, shorter-term motivation. Unless productivity picks up meaningfully, Australia is likely to have to endure a longer period of weak demand and higher interest rates to get inflation to fall.

This article first appeared in The Australian Financial Review on 16 September 2024.