Inflation, real wages and monetary policy

So the cash rate has gone up to 7.25%, and the banks will probably raise their lending rates by more than 0.25%. We all understand the official reasons why the RBA has done this. The inflation rate is too high and shows no immediate signs of falling. It’s too high because total spending on domestic goods and services has grown faster than the economy’s productivity capacity, giving rise to bottlenecks and labour shortages. Higher interest rates will curb spending — not in absolute terms but relative to trend. In the textbooks this is supposed to work by reducing business and new residential investment, but in the popular mind it works like taxation, reducing the discretionary income of households in debt (the interest goes to indirectly to other households, of course, but these generally have a higher propensity to save). The actual ‘transmission mechanisms’ that operate in a given episode of monetary tightening or loosening are hard to discern even in hindsight.

Most of the discussion in the mainstream has been about whether the Bank should have acted earlier, whether in these circumstances the Government should proceed with the tax cuts, and whether the high rates are starting to bite yet. Some economist bloggers have been more dovish, including John Quiggin yesterday. Fred Argy opposed the last two rises, stressing the mortgage distress, and advocating a battery of long-term measures to reduce the NAIRU. Harry Clarke, while objecting to the NAIRU concept and emphasising deregulation more than Fred, also prefers policies to reduce labour market frictions.

While I’m sympathetic to Fred’s overall program, I think that the case for reigning in the growth rate is stronger than he concedes. In particular, I disagree with his suggestion here and here that that the Bank should hold off because the current high inflation is due to ‘cost-push’ factors rather than ‘demand-pull’. In this situation, forcing up interest rates to curtail spending is seen as the wrong remedy. I’ve heard this in various quarters.

One kind of counterarguement sees a central bank’s role largely in terms of expectations and psychology. From this point of view it doesn’t really matter what the fundamental determinants are, as long as everyone knows that the Bank is committed to a hard and fast target, and will do whatever it takes when the inflation rate strays from that target. This gives firms and workers confidence, so the story goes, when they come to revise their respective catalogues and wage bargains, that they don’t need to factor in higher than normal labour costs and consumer prices.

Fred favours a less rigid approach that tolerates bursts of inflation that appear to be due to temporary shocks. And if that were the only argument, I would agree. But there’s a more fundamental one.

The textbook theory tells us that a supply shock ‘shifts the short run aggregate supply schedule to the left’, which means there will be an initial rise in prices (over and above the prevailing inertial rate) and a contraction of domestic output and employment (relative to trend). If the shock is only temporary, then activity will return to its initial level, and a bit of extra stimulus (say, from a tax cut) would even be helpful in speeding things up. In any case, prices will rise, but as long as wages don’t rise more than proportionately in the meantime, that should be the end of the story and the burst of inflation should come to a halt.

If, however, the shock is permament (the ‘long run aggregate supply schedule’ has moved to the left as well), then the above argument doesn’t apply. If non-wage costs are permanently higher, then the curent level of activity can’t be sustained unless workers and/or firms lower their expectations in terms of the real wages and profit margins they are prepared to accept. Assuming they don’t, and assuming the labour supply isn’t completely wage-inelastic, some workers will withdraw their labour. It follows that the cost shock implies a downward revision of the GDP growth rate in the period when this adjustment in activity is occurring. And it makes sense for the Bank to curtail domestic spending if it threatens to significantly exceed this implied lower growth rate.

Thus the reasoning that applies to cost-push inflation, caused by oil price shocks and so on, is fundamentally the same as that which applies to ‘demand-pull’ inflation caused by spontaneous excessive spending growth. That is, it’s still necessary for the authorites to contain spending. Note that the slower growth rate shouldn’t increase the unemployment rate in the long run, because the labour-force participation rate will go down at the same time thanks to lower real wages for marginal workers. In practice, however, participation adjusts with a lag, so unemployment will rise for a while.

The big problem, of course, is that no one really ever knows where the long run aggregate supply schedule is. It’s a question of labour market equilibrium in some sense, but it’s a mistake to identify full employment as a particular rate of unemployment (the NAIRU), for the reason just given. In principle, there is some maximum number of workers that can be productively employed at a wage that’s acceptable to both the workers and their employers. In principle, macro policy should aim to keep spending (on domestic goods) at this level. And in principle, the movement of aggregate wages should be a guide to whether the current level of employment is to the left or the right of the sustainable equilibrium.

Source. This statistic was altered markedly in favour of capital during the Accord years. It stabilised in the earlier enterprise bargaining years, but has been in gradual decline for most of the Howard era.

Unfortunately, a policy to this effect presupposes that we know what constitutes an equilibrium or normal wage share, or where it should be trending. But we don’t. Real Unit Labour Costs, which are the usual indicator of real wages, having been falling gradually since the start of the century. That is, money wages as measured by the ABS’s ‘Wage Price Index’, have risen about 30% since 2000, (around 3.8% annually), while productivity and the general price level (measured by the GDP deflator) have increased by about 31% and 19% respectively (2.5% and 2.9% annually).

The Bank Board knows that, (yet again) in principle, wage trends should be the key to just about everything, but the most they can say is:

Despite the tight conditions in the labour market, the wage price index (WPI) had maintained a steady growth rate of around 4 per cent per annum. Another measure average earnings per employee from the national accounts suggested that there had been a noticeable pick-up in wage growth, though this indicator was subject to significant volatility.

It’s true that that the December WPI increase was a little higher at 4.6% than the average for the last year, and that the year’s average of 4.2% is higher than for the rest of the decade. On the other hand, the trend has been downhill for a long time, and it has to stop somewhere. Even with that increase, real wages are still barely keeping abreast with productivity.

The bottom line is that the RBA, like everyone else, is operating very much in the dark. Nonethleless, the Board will be watching the March quarter WPI closely. As they say.

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John Quiggin
John Quiggin
16 years ago

All of this is compelling, as long as you ignore what’s happening overseas. But throw in the possibility of a sudden escalation in the global credit crisis and things get more difficult.

16 years ago

we had a taste of that during the Asian crisis and it only put a small dent in our economic growth as msot of the impact was felt in the exchange rate heading below 50 cents. That crisis was as big as they come in terms odf the regional impact. If it’s mining your implying it covers about 5% of the economy according to the OCED stats that Fyodor recently sleuthed, so it doesn’t appear to be very big (although it would hurt).
So outside influences do hurt although they have nowhere near as big an infleunce as domestic policy impacting on the economy.

Sinclair Davidson
Sinclair Davidson
16 years ago

JC – there is a chance that global growth will slow down quite appreciably and if so Australia will have exactly the wrong policy settings. So the RBA and the government face substantial uncertainty and that’s probably one of the reasons why Rudd won’t want to pay the tax cuts into super. The current situation isn’t equivalent to the Asian crisis.

Although, I’m a bit more optimistic than John is on the intenational front (a mild US recession won’t affect us that much, but a severe recession might), tightening the labour market and raising interest rates when the economy is slowing down will be judged quite harshly, in retrospect, if there is a recession.

James – the link to the figure appears broken.

16 years ago

Thanks Sinc.
Yes, there is a cause for concern if the global economy dips hard, but so far estimates show it isn’t going to be much.

The forward curve for some of the commodities isn’t showing any appreciable slowdown for 09. Coal is a good example. Although coal prices have been hit with bad weather causing shortages to develop and prices to spike…. some of the stuff went from $40 a ton to $130 on the spot market, the forward curve is showing only a about a 5 buck discount which is actually quite astounding. Maybe this is simply indicating further US$ weakness, but the volumes are expected to remain pretty high. So the forward curve for coal isn’t showing appreciable danger of a big slowing and that ought to be a loud canary in the mine (no pun intended. Moreover the annual song and dance with the japanese indicates that the one year contract negotiations are going to be excellent.

Our rates are pretty high, possibly too high and they could come down a long way if needed.

We have tax cuts coming up which in a slowdown look like an accidental blessing.

Our exchange rate is pretty high and it could easily go lower in a slowdown very quickly.

The point I was making is that the international situation shouldn’t necessarily be as bad as a material domestic policy error such as tightening up the labor market at exactly the wrong time. So I fear a domestic policy mistake rather than just a slowdown internationally.

Your point though was pretty spot on in terms of having a questionable policy mix. Don’t you think that shows potent5ial problems could be home grown more so than sidewinders coming from overseas?

The real risk we have is that the consumer is highly leveraged, so I hope we don’t have a domestic policy mistake as that could dump a lot of cadavers on the road.

Joshua Gans
16 years ago

Thanks, Sinclair. Fixed.

Fred Argy
Fred Argy
16 years ago

James, thanks for your perceptive and balanced piece. My OLO paper was mainly focused on the long term relationship between unemployment and inflation but I did express a view in the paper (as indeed two months earlier) that in the short term the RBA was in danger of over-reacting (and the latest consumer sentiment figures reinforce this concern).

My short term concerns were based on two propositions. First, that the acceleration in domestic inflation is much more a product of overseas cost-push than domestic demand pull relative to productive capacity, being triggered mainly by a combination of (a) rising oil, energy and food prices (b) the indirect effects of these external cost-push forces and (c) a structural mismatch between demand and supply. In such circumstances, any attempt to curb aggregate domestic demand through higher interest rates will do little for inflation and only push up unemployment.

The second premise underlying my short term concerns was that the RBA may have under-estimated the strength of the cumulative deflationary forces already in the pipeline (the slow down in world economic growth, the high $A, potential wealth effects, the increased risk aversion in debt markets, the loss of trust, the lagged impact of past increases in borrowing rates etc.). These forces, I thought, would slowly but surely curb both domestic demand and some of the inflationary pressures. TWe did not require more interest rate rises which of course we got.

James, I think you query my first proposition on the ground that whether it is cost-push or demand pull, there is a need to curb inflationary expectations and preempt changes in wage demands and price settings. This is a fair point. But if my second proposition is correct, underlying inflation will ease off anyway (even without central bank action) – not so much in the Mrch quarter but the June and September quarters. This will deflate infaltionary expectations. It is indeed what Bernake has been repeatedly saying.

Still, the RBA has been fine tuning the economy brilliantly since the mid 1990s so it may well prove right on this occasion too. There is a case (which I do not accept but it is legitmate) that, although world and market events are uncertain, it is better to act firmly now and then cut interest rates later if necessary.

By the way, on the risk of a new wage-price cycle and worsening inflationary expectations, I really doubt that either Harper or the Unions can do much damage in the present decentralized labour market. And ACTU secretary Jeff Lawrence is right to remind us that higher managerial salaries have been growing by double digit figures and are now up to 50 to 100 times median earnings. It is ludicrous to argue that CEO remuneration is market determined when anyone who has served on a Board knows the CEO and related market is set by insiders for insiders. Nor are there effective shareholder disciplines in place. At a time when shareholders are taking a beating in part because of managerial greed and incompetence and at a time when the Rudd Government has taken the lead by freezing parliamentary remuneration, it is surely about time for some of our CEOs to show moral leadership and promise to keep their firms managerial pay unchanged for at least twelve months and subsequently link their remuneration more effectively to their companys performance relative to its peers. If some our leaders take the lead, others will follow.

Joshua Gans
16 years ago

Thanks for the lengthy reply, Fred.

My main consideration, which I don’t think has received enough attention in debates about monetary policy (although Harry has certainly raised it), is that we have to get used to more expensive energy in the medium term. Real wages and/or profit expectations have to adjust downward (relative to trend). And if this means a contraction of labour supply and a lower full-employment level of activity, it needs to be recognised in targets for growth while that adjustment is underway. (On the other hand, if we’re on the backward-bending section of the aggregate labour supply curve, it’s a different story.)

Against that is my doubt that we can easily identify any equilibrium real wage level (or path), given the decline (relative to productivity) of the last decade. So the bottom line is that I really don’t know what to think.

Finaly, if JQ is right, and he usually is, the world economy will give us the slowdown we had to have anyway.

Fred Argy
Fred Argy
16 years ago