Why Australian inflation will remain benign

Chief Economist's View

At the Forum on Central Banking, hosted by the ECB in Portugal, Reserve Bank of Australia (RBA) Governor, Dr Phillip Lowe, identified weak wage growth as the cause of a below-target rate of underlying inflation. However, the weakness in wage growth is occurring within the backdrop of strong employment growth and a falling unemployment rate; conditions which would usually be expected to drive wage growth higher than its current tepid pace of just over 2% per annum.

According to Dr Lowe’s analysis, the relationship between wage growth, employment growth and the unemployment rate has undergone a fundamental shift. Dr Lowe pointed out that the lack of wage growth, despite healthy economic and labour market performance, is a global phenomenon and cited three key explanatory factors: improved industrial relations, labour-saving technological change and the impact of globalisation.

The decline in union power in most advanced economies has meant a change in the trade-off between jobs and wage growth in favour of jobs. The influence of labour-saving technological change is less straight forward.

The most visible labour-market impact of the adoption of automation, artificial intelligence, etc. is to make many jobs redundant. The workers who lose their jobs in this process can place downward pressure on wages by swelling the ranks of the unemployed (not the current situation) or by being forced into lower skilled and lower paid jobs in mainly labour-intensive service sectors.

However, by dramatically reducing labour costs, profitability is boosted and drives businesses to invest and expand, creating job opportunities. Usually, this process will lead to firms bidding up wages as they search for workers as part of their expansion plans.

Disrupting this usual process, according to Dr Lowe, have been the forces of globalisation that are leading to businesses in advanced economies like Australia coming under increasing competitive pressure from businesses in emerging economies as global trade expands. The key competitive advantage that businesses in emerging market economies have over businesses in advanced economies is lower wage costs.

Therefore, businesses in advanced economies are unwilling to pay higher wages to domestic workers, even as shortages in the labour market emerge, as global competitive forces crimp profit margins and the ability of firms to absorb increased costs. Of course, another mechanism to maintain international competitiveness is for a depreciation of the exchange rate.

But with many emerging market economies’ exchange rates pegged to the US dollar and with constraints on capital flows, the lack of full exchange rate adjustment forces the required improvement in competitiveness back on wages. Wage pressure becomes most acute in those industries that are most exposed to international competition such as manufacturing, agriculture and mining, but increasingly includes services industries such as hospitality (tourism) and educational services.

Unfortunately, the lack of wage growth for large parts of the US population has led to rising dissatisfaction and resentment to global trade, even if part of the greater flexibility in wages and strong economic growth has meant record low levels in the unemployment rate. This has led to a backlash against globalisation and given rise to the prospect of a full-blown trade war.

An escalation in the tariff war between the US and everyone else threatens to disrupt the view that the next move by RBA will be to increase the cash rate. The current tariffs imposed by the US and China are not sufficient to significantly impact the Australian economy.

However, our analysis suggests that an escalation across US, China, Europe and NAFTA that led to an equivalent of 10% tariffs, bilaterally with the US, could lead to recession in the US, and a sharp slowdown in the Chinese and Australian economies. This scenario could find the RBA forced to cut rates, despite misgivings about household debt and house prices.

 

Table 1: Financial market movements, 14 - 21 June 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,749.8

-1.2%

US

2.90%

-3.8 bps

US Dollar Index (DXY)

94.86

0.0%

Nikkei 225

22,693.0

-0.2%

Japan

0.04%

-0.3 bps

USD-JPY

110.55

0.5%

FTSE 100

7,556.4

-2.7%

UK

1.28%

-5.7 bps

GBP-USD

1.313

-2.2%

DAX

12,511.9

-4.5%

Germany

0.34%

-9.1 bps

EUR-USD

1.154

-2.4%

S&P/ASX 200

6,232.1

3.6%

Australia

2.67%

-4.9 bps

AUD-USD

0.737

-2.4%

Source: Bloomberg

 For economic update by region, click here.

 

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