How Australia aiming for full employment could lead to higher wages

It hasn’t been seen since the 1970s but the Reserve Bank is finally aiming for something that could see all of our pay packets dramatically increase.

How would you like to live in a country that got rid of unemployment? Sound nice? Well now you might just get the chance, with the announcement last week by the RBA boss that he is now aiming to get Australia to “full employment”.

That’s right, after years of mucking round, Australia’s central bank is going to drop the hammer and go for it. Unemployment could drop from its current levels of 6.4 per cent to around 4 per cent, Reserve Bank Governor Philip Lowe has said. Maybe even lower. When pressed, he admitted full employment might even correspond to unemployment of 3 per cent.

As the next graph shows, Australia last had truly low unemployment in the 1970s. Look at that glorious period from 1940 to 1971. Those were bountiful days where everyone who wanted a job could get one. And finally we’re saying: It’s worth trying to get back there.

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Unemployment under 3 per cent would take Australia back to figures not seen since the ’70s.

So why weren’t we doing this all along?

The answer comes from thinking about the economy like an engine. You want it to be warm, but not too hot. In the economy, employment is like speed and inflation is like heat. If you smash the accelerator you can go really fast, i.e. get low unemployment, but you risk ending up with an engine that is overheating, i.e. high inflation.

There’s a trade-off between unemployment and inflation in the short run. And economists are frightened of inflation. Justifiably frightened.

DO WE HAVE INFLATION NOW?

No. Inflation is low.

People sometimes write to me to tell me inflation is off the hook because something that cost $1 a decade ago costs $1.40 now. Nope. That’s consistent with inflation of about 3 per cent a year. People are good at noticing price changes but bad at noticing the time period the change happens over. High inflation is not prices rising by 40 per cent in a decade, it’s prices rising by 40 per cent in two years.

Here’s an example to show you how bad 16 per cent inflation would be: After 10 years, at 16 per cent inflation, something originally priced at $1 would cost $5. Imagine if petrol had gone up to $5 a litre since 2011. There’d be riots – people get cross when it goes over $1.50! There’s a reason we try to keep inflation down.

That 16 per cent inflation is not some arbitrary number. That’s how high inflation was in the mid-1970s, as this next graph of inflation shows.

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In the 1990s a target on inflation was introduced. Sources: RBA; ABS

Getting inflation low and keeping it low was the big achievement of the last 30 years. This has been the big job of the RBA since the early 1990s: targeting inflation. They are forever tweaking the interest rate to try to keep the economic engine warm but not too hot.

When they cut rates, they are trying to make the economy run hotter (more spending, more borrowing, more wages growth, slightly higher consumer price inflation).

But now, inflation is really low. It turned negative briefly this year and it has been years since it was in the 2 per cent to 3 per cent range the RBA aims for. What’s more, the same is true in most economies. There hasn’t been high inflation in Japan, US or Europe for years.

The theory is now the world has changed – we can smash the accelerator without generating too much heat. We can get unemployment way down without generating dangerous inflation. (Inflation in consumer goods anyway, housing is another story!)

The last RBA Governor, a man named Glenn Stevens, barely spoke about full employment. The current governor, Philip Lowe, talks about it all the time. He has made it his mission.

“We want to see a return to full employment in Australia and inflation sustainably within the 2 to 3 per cent target range,” he said last week. “These are our goals and we are committed to achieving them.”

If he can achieve that, it will be pretty exciting. Not just for the unemployed and the underemployed, but for anyone who’d like a wage rise. There’s not much chance of companies offering big pay rises when there’s a large stock of unemployed (and underemployed) people out there. But when the labour market gets tighter, they will need to offer more money to tempt people to come work for them.

Lower unemployment, higher wages. It sounds idyllic. Almost too good to be true. But at least, finally, we’re aiming for it.

Jason Murphy is an economist | @jasemurphy. He is the author of the book Incentivology