What is now the equilibrium unemployment rate in Australia?

Unemployment fell as low as 4.3% of the work force in December 2007 the lowest rate for 30 years. While there is still much hidden unemployment (under-employed and discouraged workers), this too has been falling. Should we rejoice or have we been living in a fools paradise? Is it possible that the beautiful employment outcomes of the last couple of years were in part at least an unsustainable mirage?

There is another way of asking the same question: is Australias equilibrium unemployment rate the core or underlying rate of unemployment consistent with low and non-accelerating inflation, often called the NAIRU higher than the present rate of 4.3%?

I have not done any special recent research on unemployment but drawing on my past knowledge and experience, I want to offer my personal opinion on the question I posed – in the hope of starting a useful debate on an important policy issue.

Significance of the NAIRU

Elusive as it is, the concept of the NAIRU is an important guide to policy. When unemployment is above the NAIRU, there is scope for monetary and fiscal stimulus. When unemployment reaches it equilibrium rate, a government wishing to reduce the actual rate further cannot hope to do it by stimulating aggregate demand as such action would mainly lead to higher underlying or core inflation and do nothing for employment. At that point, if a Government wants to lower unemployment rates further, it must look for ways of improving the structural flexibility of the economy.

So it is crucial for governments to make a judgment on the NAIRU. This is the big challenge now facing the authorities.

What drives the NAIRU?

The equilibrium unemployment rate or NAIRU is not a figure inscribed in cement. In fact perceptions of it change significantly over time. In Australia, It was estimated at 3 % or so in the 1960s. It then probably peaked during the period between the mid 70s and early 90s, when economists thought it was as high as 8%. Over the subsequent fifteen years or so, it seemed to fall sharply. By 2007, many economists and politicians began to believe that the NAIRU was as low as 4% or less – that is, it was thought that an unemployment rate of 4% would be consistent with 2 to 3% underlying inflation. This view is now being challenged (see later).

Why have perceptions of the NAIRU fluctuated over the last forty to fifty years?

The NAIRU can be affected by the pace and character of structural change and by recent employment experience e.g. periods of intense and prolonged recession such as in the early 80s and 90s tend to increase the risk that workers become or are seen to become unemployable at the prevailing minimum wage. Such factors aside, there are two key forces impacting on the NAIRU.

One comes under the heading of exogenous shocks such as a sustained increase in oil and food prices. Per se, this cost-push effect impacts on headline inflation but not directly on core inflation. But if it starts a wage-price cycle it can raise the core inflation rate at any given unemployment rate. This is what happened in the 1970s and 1980s and even today there is a risk (although smaller than in the past because the labour market is more flexible) that the same vicious cycle can repeat itself.

The other key factor affecting the NAIRU is microeconomic policy. This has been pushing down the NAIRU since the 1980s. For example, the deregulation of financial markets and the freeing up of external trade provided a safety valve for excess aggregate demand, making it impact more on the external account deficit (which policy makers dont worry about) than on inflation (which they do worry about). Again, over the last 15 years, the risk of autonomous wage shocks has been lowered by the shift to decentralized enterprise bargaining (which limited the extent to which wage pressures in tight sectors of the economy are transmitted to other sectors) and greater workplace flexibility (which increased organizational and managerial autonomy). As well, the new welfare to work policies helped to reduce voluntary unemployment. All these factors put strong downward pressure on the NAIRU in the 1980s, 9os and thereafter.

What is the present NAIRU in Australia?

Against this background, I suspect the NAIRU is now between 5 and 5.5%. I come to this conclusion in three steps.

I believe the core inflation rate was nudging the upper end of the RBA range by the March quarter of 2007 and exceeded it by the June and September quarters of 2007. So 4 to 4.5% unemployment was clearly too low relative to the equilibrium rate even before the external shocks came into play.

The burst in oil and food prices since mid 2007 and their wider ramifications across the economy must have nudged up the equilibrium unemployment rate further. Although wage pressures are not yet evident, the shock December quarter CPI is worrying symptom of what might be happening to price expectations and pressures.

As well, the recent shift in attitudes to credit risk and associated increase in the cost of borrowing is tending to push up the NAIRU (more cost inflation at any given level of unemployment)..

So we may have to live with a higher unemployment rate than the present 4.3% for a period at least until oil, food and credit pressures ease and inflation expectations are again scaled down.

Policy implications

In this fluid environment, what role should the monetary and fiscal authorities play?

The big unknown is what will happen to the Australian economy if current monetary and fiscal policies remain broadly unchanged. There are three possible scenarios.

The most likely one is that the external shocks (if they persist) will push up actual as well as equilibrium unemployment rates- through secondary effects on consumption (wealth, oil and food price effects), on exports (lower commodity prices and lower manufacturing exports) and on business confidence. If this happened, it would relieve the skills shortages and dampen wage-price pressures and unemployment could creep up to its new equilibrium level. If the RBA firmly backed this scenario, and it proved correct, it could simply do nothing more on monetary policy.

If the judgment proved incorrect and the momentum of growth continued unabated – which is my second scenario – the Bank could then belatedly have to act to crack down on inflation. No great damage done by the delay. But if this is the favoured scenario of the RBA, it will move pre-emptively on interest rates in February.

The third scenario would be a really severe economic slow down in 2008/9 one which threatened a rise in Australian unemployment to 6% or 7% – well above the equilibrium rate. The Reserve Bank would then have to consider switching gear and easing monetary policy but, for the same reasons as in the USA, this might not be enough on its own to revive the economy. Monetary policy would need to be backed by fiscal policy. If a fiscal stimulus were needed sometime in the future, it should be capable of quick implementation and fairly quick withdrawal when economic conditions changed. And it should aim to achieve longer term economic and social benefits over and above short-term stabilization. Hopefully, by the time urgent action is needed, the new Infrastructure Australia body might be in a position to recommend some short-gestation infrastructure projects with high benefit cost ratios which could be put immediately into action and help to relieve bottlenecks in the economy. If the authorities acted promptly, the unemployment rate would quickly be restored to its equilibrium rate of 5 to 5.5%.

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While for the present 4% unemployment is unattainable (a) macroeconomic policy can esnure actual unemployment does not rise above the new equilibrium and (b) at the more micro level, there is much governments can do to reduce the NAIRU to 4% or so in the longer term e.g. through supply-side measures which deal with our skills shortages and economic bottlenecks, reduce federal-state duplication and promote stronger competition policies and a flexible (while fair) labour market.

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observa
observa
13 years ago

“What is the present NAIRU in Australia?”
We might be able to ascertain its true level once the money supply is relatively static.

hc
hc
13 years ago

The NAIRU is total fantasy and the RBA board have said explicitly that they do not make monetary policy decisions based on it. For much of the Post-War period unemployment was around 2% and inflation wwas negligible.

You don’t need to evoke a higher equilibrium NAIRU to explain what will happen to unemployment – the shocks buffeting the economy now will drive unemployment higher as will trade union actions to ‘preserve the real wage’ in the face of higher food and oil prices. Moreover left wing economists will support them in this foolish, self-destructive endeavour.

Lets abandon once and for all the silly idea that we can only have low steady state inflation if we retain a minimal reserve army of unemployed.

Fred, that you can justify higher unemployment as a guessed at NAIRU of 5.5% and then justify an expansionary fiscal program to get unemployment from a forecast 6-7% back to your guessed at equilibrium rate takes socialist fantasy to new heights. These are real people’s lives you are playing around with using these guessed at figures.

Your claim that inflation was taking off in March 2007 does not support the idea that unemployment was too low and your figure of 5.5% for the NAIRU is plucked from the air. We already had expensive food prices, a drought and high petrol prices in March 2007.

Lets continue with the process of liberalising labour markets so that once and for all adverse price shocks do not turn into inflationary spirals. And let’s dump the ever-changing, will-of-the-wisp NAIRU idea that encourages us to live with socially demeaning and unnecessary unemployment as the cost of avoiding trade union gernerated cost-push inflation.

conrad
conrad
13 years ago

The same old cheap attacks on trade unions HC. When such a small part of the population actually belongs to a trade union, its hard to see how they are responsible for inflationary spirals. As long as there are labor shortages and poor training systems that create them (probably in part caused hopeless unions and hopeless governments in the case of Australia), then people who are not in unions are going to ask for pay rises and get them (who wouldn’t?). I don’t see how union status makes any real difference to this in terms of inflation. Its easy to see this effect in places where there are essentially no unions and completely liberal labor laws. Last time I was in HK (December), they were complaining about exactly the same thing, although at least they understand where inflation is coming from (i.e., stuff bought from China, higher commodities, and higher rent — sound familiar?), and they also understand that anyone that can is going to want and try and get more money.

Fred Argy
Fred Argy
13 years ago

Harry, yours was a very unhelpful comment. You may have a lot of fun calling people like me socialists and other rude words but if you had done your homework you would have known that Treasury and RBA do indeed pay a lot of attention to the notion of an equilibrium unemployment rate (what you dismiss as a “total fantasy” and “silly idea”). The Treasury has such intense interest in the concept that in 2004-5 it devoted a special section of Budget Paper No. 1 to an analysis of the changing Phillips Curve (pp. 4.8 ff). And in his latest statement, the RBA Governor, Glenn Stevens, warns that Australia and the world may be experiencing “a somewhat less favourable short-term relationship between economic growth and inflation than the world enjoyed over the past decade”. This is an implicit recognition that an equilibrium of sorts exists.

Harry, I enjoyed reading your recent post in Kalimna on the need for governments to have regard for distribution issues. I almost felt like we were soul mates after all. But alas, you are back to your angry old ways here.

hc
hc
13 years ago

Fred, The RBA Board last year directly said that they do not use the NAIRU or the idea of some minimum level of unemployment as a precusor for dealing with inflation. A good idea too since while unemployment fell from north of 11% to around 4%, inflation fell just as dramatically.

What on earth is the use of an equilibrium idea that changes so dramatically even in the short-run?

Unemployment continued to fall over recent years as the economy was buffeted by interest rate hikes, fuel price increases and a drought that raised food prices. Why?

Instead of making angry accusations you might try to explain this history and where your figure of 5.5% for the NAIRU came from.

My claim is that it is a pure guess and in your response you have not dealt with that issue at all. In fact you dealt with none of the points I made – you just engaged in an ad hominen attack.

Marks
Marks
13 years ago

hc said: “For much of the Post-War period unemployment was around 2% and inflation was negligible.”

Given that half the population was both culturally and structurally discouraged from working well into the sixties and seventies, I am not sure what you could conclude from that.

Put another way, if you have a big pool of people out there who you can call on by removing cultural and structural barriers, then the effect on inflation presumably might be small if you undertake those cultural and structural reforms. If otoh, there is no such pool out there, labour shortages would presumably affect inflation. So the critical question is how well do the various measures of unemployment actually measure unemployment. If they don’t, then trying to look for some sort of equilibrium based on ‘unemployment figures’ is a fool’s game.

Fred Argy
Fred Argy
13 years ago

HC, in both your interventions you ask a lot of interesting questions but unfortunately they are irrelevant to the one I posed.

I suppose we could discuss your questions. If you really want my opinion on “why unemployment continued to fall over recent years”, I would point to a very strong world economy (falling unemployment was far from unique to Australia) and the effect of the terms of trade bonanaza on average disposable incomes. Improvements in labour market flexibility helped but they were only marginally a product of WorkChoices. By the way, it is the core or underlying rate of inflation that the Bank focuses on: movements in oil and food prices have no direct effect on that. And where on earth did you get the idea that I was in favour of “a reserve army of unemployed”? The NAIRU reflects frictional and voluntary unemployment plus an unknown structural element due to mismatch between vacancies and unemployed. It is an irreducible minimum in the short term. And we live in the short term, Harry.

My point however is that, while we could debate these questions ad nauseum, they are not relevant to the one I sought to discuss in my post, which is: is Australia’s present unemployment rate of 4.3% sustainable (consistent with low and non-accelerating inflation)? My answer is no – at least for the next year or two. I agree my 5 to 5.5% is a “guesstimate” – remember I am long retired with no research facilities to draw on. If, with better resources, you can arrive at a superior estimate it would be great.

Once you start addressing the question that I posed instead of pronouncing it a fantasy question, I would be happy to debate you further.

hc
hc
13 years ago

I agree with the factors you mention reducing unemployment and that is why the NAIRU is irrelevant.

The idea that you need to keep a pool of unemployed to maintain price stability is similar to Marx’s idea of the ‘reserve army of unemployed’. It disciplines labour and keeps a check on wages. This might be necessary if monopsonistic trade unions force wage decisions but is not true if workers are paid their marginal product because of competition.

I won’t be researching the NAIRU as I don’t believe it is relevant for macroeconomic policy. I recall the estimates of NAIRU made a decade ago of 7% plus that were made by technically competent econometricians but which were a mile wide of the mark.

The important issue now is to prevent trade unions from seeking catch-up for externally imposed price increases that can initiate an inflationary spiral. It is also vital to pursue flexible well-informed labour markets that allow real wages to fall in the short-run as well as rise. This can drive unemployment below 4% and with the right sort of monetary discipline can also leave Australia with low inflation.

conrad
conrad
13 years ago

HC,

you have trade-union paranoia — the number of effective trade unions that are left in Australia that have the sort of bargaining power you are talking about is close to zero. In fact, in some cases, like education, the opposite is true. The government did such a good job destroying the teacher’s union and the NTEU and such a poor job at being basically the sole buyer of these services that the entired system from primary schools to universities is basically screwed and living on borrowed time (you can reflect on what the last 15 years to La Trobe if you like — and you’re in a lucky area gifted by the windfall of OS students). Given this, its seems to me that the people that are going to cause an inflationary spiral are all those that there simply are not enough of — and most of these don’t belong to a union at all. If your dentist, accountant, plumber, surgeon, etc. want to charge you 20% more than last year, is there anything you can really do about it? If you own a company and need a competent civil engineer and they want 20K more than last year, are you simply going to go without?

Fred Argy
Fred Argy
13 years ago

Harry, thanks for keeping up the discussion. We are beginning to narrow the disagreement between us.

I believe we need to distinguish between two distinct questions. The first is whether unemployment will rise in the months ahead. We both agree that it will because of world pressures and the malaise in financial markets.

The other question – which goes to the essence of my post – is: would a fiscal or monetary stimulus help to avert such a rise in unemployment? My answer to this question is no because unemployment would be unresponsive to increases in aggregate demand. We would only get worse inflation if we tried to stop the rise in unemployment. However if the unemployment rate rose to 6 or 7% – which I believe would be above the equilibrium rate – it would make sense at that point to change to a more expansionary monetary and fiscal stance. That in a nutshell is my theme.

I agree with you that it is vitally important for the authorities to ensure that food and oil price increases do not start another wage-price cycle. But I happen to believe the labour market already has enough built-in disciplines of its own to prevent this happening and the new Rudd-Gillard regime will not make things worse.

Robert Braby
Robert Braby
13 years ago

Fred, there is much sense in what you say, but I would like to tackle the matter from a different angle.
The last time I looked at this (14 years ago), empirical estimates of the NAIRU differed substantially from estimates of Full Employment (a different concept). I attributed this to the serious bout of cost inflation (oil and wages) which following the OPEC rises of the early 1970s, forcing the authorities to engage in contractionary measures leading to higher equilibrium unemployment.
Now that cost inflation has almost abated (for the present), I think we can say that the NAIRU and F.E. are about the same. But I would guess this to be 5% or more, not the 2% we came to associate with F.E in the 1960s. What has changed? Probably a number of things, but a major one I believe is the threat to our environmental sustainability. Let me explain.
The symptoms of excess demand and over-full employment at present are:
1. Underlying inflation over 3%, and
2. Our reliance on immmigration to meet labour shortages (not only skilled labour e.g. fruit pickers). This is really disguised inflation (and should be factored into any Phillips curve analysis).

But whereas immigration was not regarded as a problem 40 years ago, today it is contributing to very serious environmental problems, most notably water shortages, at least in Victoria where Melbourne is on stage 3A water restrictions and some country towns on stage 4.
The notion that we can solve the skilled labour crisis by immigration is a hoax, perpetrated by politicians and their supporters in the property market and business generally.
p.s. Harry will have a fit if he reads this, but it is time economists took environmental sustainability seriously. After all, scarcity is the basis of economics.

Fred Argy
Fred Argy
13 years ago

Thank you Robert. I am in two minds about immigration. Wearing my economist hat, I see it as yet another safety valve in the system. Like larger imports or wage disciplines, resort to temporary migrant workers can cushion the effects of excess aggregate demand. Instead of impacting on inflation the excess demand impacts on the external account deficit and on population flows. In that sense it tends to reduce the NAIRU.

On the other hand I share your concerns about the effects of high immigration on house prices, on our limited water resources, on rivers etc. These have an economic as well as environmental cost.

Robert Braby
Robert Braby
13 years ago

Fred, if we use temporary immigration to cushion excess demand, then the level of immigration should be adjusted pro-cyclically if it is to be a genuine discretionary stabiliser. i.e. it should also be reduced when demand slackens. I doubt if immigration has the administrative flexibility to be used in this way, given the time lags and other practical problems involved. Also, immigrants add to demand (consumer demand, investment demand and government spending), so the cushion may be rather thin.

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