Lower productivity could be an illusion, says Westpac chief economist Luci Ellis

The slump in Australia’s labour productivity since the pandemic is unlikely to last, according to Westpac’s Luci Ellis.

Westpac chief economist Luci Ellis. Picture: John Feder

It may be a growing concern for the Reserve Bank as it battles above-target inflation, but the slump in Australia’s labour productivity since the pandemic is unlikely to last, according to Luci Ellis.

After looking at potential reasons why Australia’s productivity, or GDP per hour worked, has been negative since the pandemic, Westpac’s chief economist says it could be explained by measurement errors and changes in the composition of the workforce.

Of course, the arguments raised by RBA governor Michele Bullock in her speech this week mainly focused on the fact that inflation is already “too high”, “homegrown” and “demand-driven”.

The RBA has recently said that, at current rates, wage growth is consistent with inflation returning to target, provided productivity growth recovers – as RBA forecasts assume.

But at the ASIC annual forum this week, Bullock presented the issue differently.

She said that current rates of wage growth would be “on the high side” – in other words, inconsistent with inflation returning to the RBA’s target – if productivity growth remained at its present level.

“This was probably not intended as a change in rhetoric, but rather making the same point in a different way,” says Westpac’s Ellis, who was previously assistant governor (economic) at the RBA.

“It does suggest, though, that the RBA is getting more worried that productivity will not pick up.

“Without any kind of narrative about why productivity has fallen, though, it is hard to quantify how much weight to put on the possibility that it will not recover.”

If there are compelling reasons why Australia’s productivity will recover, the RBA is likely to assume that unit labour costs will fall to levels consistent with the inflation target. But at some point, it may worry that the fall in productivity is durable, unit labour costs aren’t consistent with its inflation target, and more rate hikes are needed to slow demand.

“For us, the assumption that productivity growth will pick up is the only thing stopping the November minutes from being more hawkish,” Citi Australia chief economist Josh Williamson says.

“But right now, non-farm unit labour costs are growing by 7.3 per cent, year on year.

“Labour cost growth needs to slow substantially to be consistent with the inflation target.”

Westpac says part of the decline in productivity stems from changes in the composition of the workforce. In other words, people have not individually become less productive; there are simply relatively more low-paying jobs than before, and they account for less GDP per hour. “If true, this is a level shift effect and should not have a lasting effect on growth in productivity,” says Westpac’s Ellis.

Another possibility is that productivity as measured in the national accounts is subject to “measurement error”. Both GDP and total hours worked are “noisy” economic variables, so their ratio is necessarily “noisier” and the change in the ratio even more so.

“It is entirely possible that the last year of data is just noise that will soon reverse out,” Ellis says.

In her view, revisions to the economic data could make the period of falling productivity look less stark, or even disappear. GDP could be revised up or total hours worked revised down, or a combination of the two.

“Even for a high-quality statistical agency like Australia’s, revisions are a fact of life, especially when population trends are shifting rapidly and compositional change in the workforce is higher than usual,” Ellis says.

It wouldn’t change the idea that domestic demand is still out of line with supply, but “it would change how one should interpret the role of wages growth in ­contributing to inflationary ­dynamics”.

One thing policymakers and other observers seeking a pattern do need to be mindful of is that unit labour costs are volatile.

“It is not appropriate to assume that one or two years of outcomes map directly into inflation,” Ellis says. “Given how little room for manoeuvre the RBA has in the face of upside surprises on inflation, their concerns are understandable. But neither should they assume that Australian workers have mysteriously become less productive.”

Meanwhile, productivity in the US and Norway is back to pre-pandemic trends.

Whatever the reasons for Australia’s poor performance, any explanation other than measurement noise has to account for the fact that productivity is also below pre-pandemic levels in Canada but not elsewhere.

In the case of the US and Norway, the pandemic effects have completely washed out.

“The recovery in the capital to labour ratio seen in the US and Norway, but not yet Australia, is more relevant,” says Westpac’s Ellis.

“Australia’s productivity slump is therefore unlikely to be lasting.”