Hope is not a strategy when it comes to lifting productivity

There’s an old story that pilots like to tell about the importance of trusting your instruments.

As the story goes, when flying through thick cloud trainee pilots who focus on what they can see out the window and not what the gauges tell them can find themselves flying upside down by the time they exit.

This story may be apocryphal but the message is clear — in times of clouded and limited visibility and uncertainty, having well-calibrated instruments and trusting them matters.

For the economy, this is surely one of those times. If anyone needed reminding, last month’s RBA statement on monetary policy used the word ‘uncertain’ 132 times, more than at any time in the past five years, including the pandemic.

For economists, a plane’s instruments can be thought of as equivalent to their economic models and assumptions. In this regard, the RBA’s and Federal Treasury assumptions and forecasts for productivity growth matter. In our view, both are unrealistically high, and by a large margin.

The RBA is assuming that productivity growth will be 0.9% over 2025, while in the May budget the Treasury forecast it to rise 1.2%. The most recent print for labour productivity showed it falling, yes falling, by 1.0% over the past year. The average rate of productivity growth over the past eight years has been 0.1% a year.

The official forecasts are ambitiously high. Without a meaningful agenda of structural reform that had already been implemented, it is hard to see how Australia’s economy sees such a sharp recovery in productivity.

When asked about the productivity outlook at the May board meeting press conference, RBA Governor, Michele Bullock, said that growth of 0.9% this year was just a working assumption, not an actual forecast.

The Federal Treasurer, Jim Chalmers, recently stated that, ‘it will take longer to make progress on productivity than it has taken us to make progress on inflation.’

It took three years to get inflation to fall back to target, so the sharp turnaround in productivity underpinning the budget and the RBA’s figures seems optimistic.

This matters for a number of reasons.

First, to fix a problem it helps to acknowledge that you have one. Hope is not a strategy. Productivity is a key driver of economic living standards, which have been falling in recent years. We see this as Australia’s biggest challenge.

Our own forecast is that productivity growth will pick up to a rate of 0.25-0.5% in the next couple of years. The difference between productivity growth of 0.25-0.5% and 0.9-1.2% means that GDP would be 6% lower in ten years’ time. That is a loss of around $6,000 in potential output per person over the next decade.

Second, for the RBA, if productivity is lower, the speed limit for sustainable growth in the economy is lower as well. On our estimates, Australia’s growth limit, or its potential growth rate, is around 1.75-2.0%, rather than the 2.4-2.7% rate that would be implied by the official productivity assumptions. For the RBA, this means that slower rates of growth could be needed to keep inflation on target. It could be that the RBA’s forecast for growth of 2.2% over 2026 may be ambitious, if inflation is also to be kept on target, which means the productivity assumptions have implications for the cash rate outlook.

Third, for the budget it means that the growth forecasts are likely to be too optimistic, which may mean the budget deficit turns out to be larger than projected.

On the policy front, we were disappointed that productivity was not a focus of the recent Federal election.

A part of the reason may be that it is hard to communicate to the public the importance of productivity. As we see it, this is just another reason to be clear and realistic about assumptions. If the message was that particular policy changes could raise people’s income by $6,000, perhaps it would cut through.

The good news is that the newly re-elected government has stated that it is seeking to make productivity growth a priority and is set to host a summit on the topic in August. The key now is delivering economic reform that achieves a pick-up in productivity.

As is well understood by observers there is no lack of ideas for reforms. Many lengthy reports have been written, reviews commissioned, and forums held. Australia’s Productivity Commission has a long list of policy reforms that could help.

As with other economic priorities — like the RBA’s inflation target — it could help to set an objective. To do this would, of course, require a realistic starting point. It would also help to track the progress of policy measures aimed at lifting productivity in order to judge if they have been successful.

The Productivity Commission could play a role here. Tracking the outcomes after a policy has been implemented and then matching them against the expectations would help to determine what works and what does not. For us, the key is to start with realistic assumptions. That way the forecasts can be better trusted, and we can limit the risks that we come out of the clouds flying upside down.