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.