Friday, 09 June, 2023
With labour costs, not profits, the biggest driver of inflation, the central bank will have to go higher to crush Australia’s wage-price spiral
Christopher Joye, portfolio manager, Coolabah Capital Investments
Over at the AFR I write that on December 9, 2021, Coolabah’s internal research team presented highly contrarian analysis regarding where the Reserve Bank of Australia would take interest rates over the coming years. This was part of a weekly “hunger games” competition that we run every Thursday where three individuals are randomly selected to pitch their best idea.
Coolabah chief macro strategist, Kieran Davies, had pulled together 24 slides of sophisticated economic modelling that argued the RBA’s cash rate would likely have to soar much further than market participants, or the RBA itself, expected. He further forecast a demand-side-driven inflation break-out powered by excessively strong wage growth.
Although the RBA would contend last year that the neutral (or normal) cash rate that was neither stimulatory nor contractionary was “at least 2.5 per cent”, Davies’ December 2021 research found that using the RBA’s own economic models, the neutral rate was actually much higher at between 3.5 and 4 per cent.
This was recently confirmed in freedom of information disclosures from the central bank in which it published internal modelling pointing towards a higher neutral rate of 3.8 per cent.
In his pitch, Davies estimated a real-time indication of the level of unemployment that was consistent with stable inflation in the middle of the RBA’s target 2-3 per cent. This is known as the “non-accelerating inflation rate of unemployment” or NAIRU. (Classic economist jargon!)
Whereas the RBA was claiming in 2021 that the NAIRU had declined into the low 4 per cent vicinity, which supported the notion that its 0.1 per cent cash rate would not trigger a wage/price spiral (given a 4.2 per cent unemployment rate), Davies’ modelling found that the NAIRU was actually 5-5.5 per cent. This implied that the labour market was running red-hot with the corollary that there was substantial upside risk to wages growth.
The bombshell was where the RBA’s cash rate would have to climb to in order to rein in the inflation shock. In December 2021, the financial market was pricing in a peak RBA rate of slightly less than 2 per cent by 2024. Davies’ modelling concluded that given a neutral cash rate of 3.5-4 per cent and a NAIRU of 5-5.25 per cent, the RBA would be compelled to lift its cash rate to between 4.6 per cent and 5.6 per cent. This was much higher than any other mainstream economists’ estimates.
Thus far, we’ve travelled from 0.1 per cent to 4.1 per cent. The RBA’s freedom of information disclosures point to the need for it to now get the cash rate to 4.8 per cent to push core inflation back down to 2.5 per cent by June 2025.
The problem is that this may be too slow. During the week, we received new evidence that Australia is grappling with a nascent wage/price spiral. The official statistician’s data highlighted that the RBA’s preferred measure of wage growth, known as unit labour costs, had expanded by an astonishing 8 per cent over the 12 months to March 2023.
The standard wage growth benchmark, known as the wage price index, measures the compositionally adjusted change in the average person’s wage earnings over time.
The more complex unit labour cost measure is broader and tracks the change in how much businesses pay employees to produce one unit of output.
In RBA governor Philip Lowe’s speech this week, he stressed that “over time, there is a close relationship between inflation and the rate of growth in unit labour costs”, which is why the RBA uses this variable to forecast inflation. And he noted that unit labour costs are running at about 7.5 per cent, “one of the largest annual increases during the inflation-targeting period”.
After he spoke, the latest data was published, documenting the 8 per cent increase in unit labour costs, which actually represents the biggest jump since 1990 (absent pandemic-induced distortions). And Lowe warned that “ongoing strong growth in unit labour costs would underpin ongoing high inflation outcomes”.
The driver of this massive labour-cost inflation – which will be amplified by the surprising 8.6 per cent increase in the minimum wage last week (and the 5.75 per cent increase in all award wages, affecting more than one in four workers) – is the poorest labour productivity that Australia has experienced since World War II.
There are many possible explanations for this productivity malaise, including: under-investment in capital and technology; business interruptions caused by the pandemic; pulling unskilled workers into jobs as the unemployment rate went to excessively low levels; and never-ending decades of prosperity dulling our incentive to work hard and generally making us entitled and lazy.
The solutions include: investing in new technology and equipment to enhance productivity (eg artificial intelligence); better utilising existing infrastructure, systems and technology (harnessing efficiencies); and, finally, the least desirable option, restructuring the workforce to produce more with fewer people.
Some claim Australia’s inflation crisis is attributable to companies profiteering through margin expansion rather than escalating labour costs. On our modelling, that is undoubtedly true for mining companies that employ few people and have recorded large profits care of commodity prices. But mining only represents 10 per cent of the economy.
Taking the latest GDP data unveiled this week, our researchers have replicated an accounting methodology adopted by the European Central Bank to break out the wages, profits and net tax contributions to inflation over time.
They find that for the remaining 90 per cent of the non-mining economy, labour costs, not profits, are the biggest driver of recent inflation. Specifically, Davies comments: “Non-mining prices are up 7 per cent over the last year, reflecting a 4.4 percentage point contribution from higher unit wages, 2.3 percentage points from unit profits and 0.3 percentage points from unit net taxes.”
Cracking open the non-mining economy further to focus on inflation in the cost of household services and retail trade, the price of household services is up 8 per cent over the past year, driven by a 5 percentage point contribution from unit wages, 2 percentage points from unit profits, and one percentage point from net taxes.
Finally, the 14 per cent trend increase in retail prices reflects an 8 percentage point contribution from unit wages, 5 percentage points from unit profits, and one percentage point from net taxes.
Drawing all this together, Davies stands by his December 2021 analysis and says: “Getting inflation under control within a reasonable timeframe will require the RBA to fall into line with peer policy rates and continue to lift its cash rate target into the high 4 to low 5 per cent range.”
More stress ahead
This will inevitably create a lot of stress for riskier businesses and households that have borrowed in recent years assuming rates would remain low. The RBA’s research found that at a 3.6 per cent cash rate, about 15 per cent of all borrowers would have negative cash flows.
This week an investment bank updated these estimates to allow for the now much higher expected cash rate profile. It concluded that at a 4.6 per cent cash rate, which is at the lower end of Davies’ projected range, 19 per cent of all borrowers would have negative cash flows. At this threshold, 28 per cent of all borrowers would have suffered an 80 per cent reduction in their free cash flows.
This will underpin the mother of all default cycles, which we have been projecting since late 2021. Our recession forecasts are also quickly coming to fruition. Since January 2022, we have argued that the US and Europe would experience recession in 2023 or 2024. Data released overnight showed that the Eurozone has suffered two consecutive quarters of negative GDP growth with much worse to come (as the US technically did in 2022).
This is also bad news for Aussie house prices. In June 2022, just after the RBA started raising rates to 0.85 per cent, we released research showing that if one took the financial market’s upwardly revised estimate of the RBA’s peak cash rate, which had jumped to 4.25 per cent, Aussie house prices would need to adjust down by more than they ever have.
We got the first part of that adjustment with the daily five-capital city index from CoreLogic slumping by 10 per cent between May 2022 and February 2023, its second-largest loss in 40 years (Sydney prices plunged 14 per cent). We should get a second leg to the correction starting soon.
A few nights ago, Australia’s top residential real estate agent, Alexander Phillips, who sells more than $1 billion of homes a year, called to pass on the message that the “market is turning fast”. He said his phone had been inundated with nervous vendors wanting to quickly list homes to catch the current bounce. Phillips thinks “the capital gains between February and May will be wiped out by year-end if the RBA keeps hiking”. For the time being, prices continue to climb.
Strong unit labour costs account for high domestic inflation …
Strong unit labour costs also drive high household services & retail inflation.