24 May 2023

Tame wages could mean a ‘fairytale’ soft landing

Not-too-hot and not-too-cold. Much like Goldilocks’ porridge, the recent pick-up in wages growth in Australia has been just about right, at least from the RBA’s perspective. The numbers also showed that the pulse of wages growth is already easing a bit, even though the unemployment rate has only risen a little and is around a multi-decade low. The fairytale ending would be that this comparatively tame pick-up in wages growth means inflation returns to the RBA’s 2-3% target range without a large rise in the unemployment rate.

Last week’s figures showed the wage price index rose by 3.7% over the past year, up from around 2.0% in the pre-pandemic period. As the RBA has stated repeatedly, assuming that productivity growth runs at its recent decade average of around 1% a year, annual wages growth of 3-4% is consistent with the central bank’s 2-3% inflation target. The pulse of wages growth is also already easing a bit, even though the unemployment rate has only risen a little and is around a multi-decade low.

A look across the world tells us that this somewhat benign combination is quite unusual. In the US, UK, much of Europe, and New Zealand, wages growth is running well ahead of the inflation targets set by the respective central banks. This is likely to make it harder to achieve lower inflation and a soft landing for the labour market.

Australia’s comparatively tame wage outcomes appear to reflect a range of factors.

First, wages growth was unusually low prior to the pandemic and this had become somewhat embedded as a ‘norm’ at the time. The low starting point meant that some pick-up in wage growth was actually needed to achieve the inflation target.

The low wage growth was partly a hangover from the ‘super-cycle’ in commodities and mining investment in the early 2000s. The mining boom drove a massive ramp up in costs, including labour costs, that took years to correct. But wages rise much more easily than they fall, as outright pay cuts are difficult for workers to absorb and hard to impose. As a result, rather than wages falling outright the growth in wages slowed down and the needed adjustment after the mining boom occurred over a number of years.

Second, Australia’s enterprise bargaining system, in which 35% of wages are on longer term agreements, typically for 2-3 years, has slowed the recent pick up in wages growth. This means it is taking time for the 2% wage rise ‘norm’ to shift across the system to a new, higher level. As a result, by the time wage pressure strengthened, the RBA was able to tighten its policy settings to seek to slow labour demand. In addition, there has been sufficient time for the labour supply to be boosted by the re-opening of the border after the pandemic.

Third, the disruptive impact of the pandemic and its related policies is starting to fade, particularly those related to the border closure. Our long-held view is that the primary driver of the recent skills shortages across the economy was the impact of the border closure. Its re-opening has led to a strong influx of migrants, which is boosting labour supply and helping to reduce the shortages. With more readily available labour, the upward pressure on wages growth is likely to subside.

Fourth, the pandemic may have led to some more sustained behavioural changes in the jobs market. The success of the ‘JobKeeper’ wage subsidy scheme in keeping workers in their pre-pandemic jobs has supported the labour force participation rate. As a result, participation has reached a new record high as the recovery has gained momentum, also boosting labour supply.

Finally, despite picking up, jobs market churn has remained quite low. This may also reflect the success of JobKeeper. Lower churn is likely to have suppressed the strength of the upswing in wages growth as job changes typically trigger larger wage gains.

Churn may also be reduced by the increased flexibility of working arrangements, including work from home, that have been a feature of the pandemic. Workers who now have more flexibility with a current employer may stay in a job longer as it is difficult to be sure that a new employer would offer the same level of flexibility. A higher wage at a new employer may not be enough to offset the risk of less flexible work arrangements.

The fairytale ending for the RBA could yet be upset by a further acceleration in wages growth. It could also be challenged if the current weak productivity growth rate does not return to its pre-pandemic average, which was unimpressive anyway, at 60-year lows.

However, if wages growth does steady from here, without a substantial rise in the unemployment rate, there is a high chance that inflation will head back to the RBA’s target range without the need for a recession. This would be an impressive outcome.

This article first appeared in the Australian Financial Review on 23 May 2023.