Australia will need economic stimulus for far longer than the treasurer thinks
The minutes of the latest Reserve Bank meeting suggest the bank and the government do not agree on when a recovery will be complete and thus for how long fiscal and monetary policy will need to stimulate the economy. It suggests that the RBA realises it will be expected to keep assisting the economy long after the government has decided the more important matter is the size of the budget deficit.
It all depends on full employment. But what is full employment?
It is a pretty disputed term among economists and the public.
The standard definition is the lowest level of unemployment at which inflation growth remains steady – the non-accelerating inflation rate of unemployment, or “Nairu”).
It’s a nice little concept but unfortunately it is not a stable rate – and as a result more than a few economists think it is a pretty useless concept.
In 2017, for example, the Reserve Bank estimated the Nairu was around 5%, whereas at the turn of the century it was thought to be around 6%.
What that means is that there may be certain points where inflation starts to accelerate because the labour market is near capacity, but you can’t really target a certain rate with much accuracy.
When we compare the unemployment rate and inflation growth (a thing known as the “Phillips curve”) since the 1990s recession, inflation remained below 3% until the unemployment rate hit around 4.3%:
Graph not appearing? View here
But while that might suggest full employment is when we get an unemployment rate of 4.3%, the problem is, from 2016 through to the start of this year, unemployment was able to reach 5% and yet not only was inflation growth not accelerating, it remained below 2%.
That suggests that inflation growth
is lower relative to unemployment than it was in the past – which is not surprising, given wages growth has also been much lower than in the past, and wages growth drives prices growth.
What we need also to realise is that the labour force is not just the employed and unemployed but also the underemployed.
When we compare inflation with underutilisation (which is unemployment plus underemployment) we see that the current level is higher than it has been since the 1990s recession, and that we need a rate of around 10.5% before inflation-starts rising:
Graph not appearing? View here But the problem is that in 2007-08, when the underutilisation rate was last under 10.5%, underemployment was only 1.8%pts higher than unemployment – now it is 4.4%pts higher: Graph not appearing? View here Even before the pandemic, underemployment was 3.5%pts higher than unemployment.
Were that gap to hold, an unemployment rate of 4.3% would see underutilisation still at 12.5% – well above the 10.5% level needed to cause inflation to begin rising.
It means unemployment would need to fall to 3.5% before underutilisation would reach 10.5%.
Why does this matter?
Well, because this week the latest Reserve Bank minutes showed the board discussing whether it needed to lower rates “towards zero”.
And while they decided not to cut rates from 0.25% at this time, they did note that “they would also like to see more than just progress towards full employment before considering an increase in the cash rate, as the board views addressing the high rate of unemployment as an important national priority.”
The phrase “more than just progress towards full employment” suggests a rather lower rate than did the treasurer in September when he stated the government’s recovery plan would “remain in place until the unemployment rate is comfortably back under 6%.”
The government’s budget suggests even by 2023 inflation will be just 2.25% at a time when it estimates unemployment will be 5.5%.
The IMF’s latest projections released last week (which draw on advice from the Treasury) suggest even by 2025 unemployment will be at 5.4% and inflation will be just 2.4% – ie in the bottom half of the RBA’s 2%-3% target range:
Graph not appearing? View here The RBA’s own projections for unemployment and inflation in the most recent Statement on Monetary Policy are for 7% unemployment at the end of 2022 and inflation of just 1.5%.
Neither the budget, the IMF, nor the RBA suggest full employment is anywhere close to happening – not even in the next five years.
And neither do any of them suggest that “comfortably below 6%” is either close or suggestive of being “more than just progress towards full employment.”
It means we have a government already lowering the bar for when it can claim the recovery is largely done and it can start reducing fiscal stimulus, while the Reserve Bank is raising the bar for when it thinks it will need to increase rates and applying the monetary policy breaks.
It also suggests we have a Reserve Bank worrying more about full employment and a government more worried about the budget deficit.