The RBA has frequently argued the short-term path to economic prosperity in the current economic climate is to leave loose monetary conditions in place such that economic growth is strong and businesses expand employing more workers and absorbing any residual slack in the labour market.
Once the unemployment rate falls below the NAIRU (Non-Accelerating Inflation Rate of Unemployment) then (by definition), inflation begins to rise. However, because demand for goods and services produced by businesses is strong these businesses are likely capacity constrained due to a shortage of workers. Under this theory, wages will rise as businesses compete with each other for labour. This is “good wage growth” as it is driven by strong business conditions meaning there is a bottleneck in the supply of labour.
In this scenario, the RBA can lift interest rates to bring the economy back into balance without deleterious effects. If individual workers are short of money to pay their mortgage and support the lifestyle they desire, they can move to a higher paying job or work more hours because the job market is strong.
The RBA has been hesitant to raise interest rates to date because wage growth has been stagnant despite the economy growing strongly, unemployment falling and inflation rising. If the RBA were to raise interest rates in this current scenario, it could simply make households “poorer” as workers are not in a position to demand a pay rise, ask for more hours or change jobs to a higher paying one because there is still slack in the labour market and employers are not finding they need to increase wages to source workers.
However, it is not as simple as the RBA simply not raising interest rates until wages start rising as there is another scenario which is far worse. This is where the RBA does nothing about rising inflation which makes workers “poorer” anyway as their wages are not keeping up with the cost of living. If this is allowed to persist these workers will increasingly “demand” higher wages in a scenario where businesses cannot afford to pay higher wages as they are still recovering from the effects of the pandemic and are not constrained by a shortage of labour. This is “bad wage growth” as there is simply disruption as workers seek pay rises to keep up with inflation without any increase in productivity and businesses are forced to put up their prices to pay for them causing greater inflation and more pay rise demands in a vicious circle.
This was the scenario in the 1970’s and early 1980’s that led to monetarist policies to control inflation, particularly crushingly high interest rates that purposely plunged many western economies into recession as the only way to break the cycle of workers continuously demanding pay rises because future inflation expectations had been set so high. In the aftermath, many central banks became “independent” with an inflation targeting mandate as a method of providing credibility that inflation would be contained going forward. In Australia, the RBA started explicitly began targeting inflation in 1993 after “the recession we had to have” partially caused by high interest rates used to control inflation in the 1980’s.
In the US, inflation is currently worryingly high and perhaps “out of control” with the US Federal Reserve’s credibility as an “inflation fighter” being severely tested. The Fed has been very slow to raise interest rates despite inflation reaching 8.5% in March 2022, its highest rate since 1981 and massively in excess of the Fed’s target level of 2.0%.
Within Australia, the RBA is beginning to face the same dilemma between raising interest rates too early and stunting nascent GDP growth and potential wages rises or raising interest rates too late and having to deal with an inflationary problem caused by workers demanding higher wages because of changed expectations regarding future inflation. This latter scenario of “bad wage growth” is by far the worse of the two outcomes because, if history is a guide, the only solution will be high unemployment and a recession to force wage pressures down to control inflation. With so much household debt in the Australian economy and many very low paid workers, such a scenario would cause a great deal of social suffering. One of the reasons we believe the market is pricing in far higher interest rates than predicted by economists and the RBA is because the market is not discounting this scenario as heavily. The RBA certainly does not wish to crush consumer and business confidence by alluding to such a possibility and potentially stalling economic growth as consumers and businesses reduce spending and investment, thus making a recession more likely.
How severe the inflation problem becomes in the US and how the RBA manages the low wage growth / rising inflation situation domestically will be a large determinant of Australia’s social and economic future in the medium term. Hopefully the RBA does not make the same policy mistakes as the Federal Reserve appears to have made (or different policy mistakes).
