RBA grapples with ’invisible but crucial’ non-inflationary unemployment level

The RBA cut rates to get a lower sustainable unemployment rate, but it admits it’s working in the dark.

Assistant governor (economic) at the Reserve Bank of Australia, Luci Ellis. Picture: John Feder.

The Reserve Bank of Australia says its decision earlier this month to start cutting interest rates for the first time in three years was to pursue a lower sustainable unemployment rate, but it admits to working in the dark.

Luci Ellis, assistant governor (economic) at the RBA, said in a speech in Melbourne the central bank considered the so-called non-inflationary level of unemployment (NAIRU) had fallen to its lowest level in at least four decades, but added that it was invisible to policy makers.

“The level of unemployment consistent with full employment might be an invisible, but it is crucial. If Australia truly can have lower unemployment – sustainably – policy should be used to try to get there,” Dr Ellis said.

RBA governor Philip Lowe told reporters last week he was operating with the view that NAIRU now sits at 4.5 per cent, down from the estimate of 5 per cent used over recent years.

The RBA cut interest rates on June 4 citing a slowdown in the world economy, slowing growth locally and sagging inflation as triggers for the move.

Core inflation in the first quarter stood at just 1.4 per cent on-year, well short the RBA’s long-term target of 2 per cent to 3 per cent, suggesting the level of full employment remains a fair way off.

The unemployment rate currently sits above 5 per cent, deepening the unease of the RBA, while raising the prospect of further interest rate cuts before the end of the year.

“There is substantial uncertainty around our estimate of the NAIRU,” Dr Ellis added.

The RBA’s own modelling estimates that there is a two-thirds chance that the current NAIRU is between 4 per cent and 5 per cent, and a 95 per cent chance it is between 3.5 per cent and 5.5 per cent.

“But given what we are seeing in the data, right now we feel comfortable about being a bit more specific than that,” Dr Ellis added.

The RBA’s task of reaching full employment could be considerable, with unemployment in the biggest state of New South Wales falling to 3.9 per cent at the start of the year without it sparking lift in wages.

Dr Ellis’ speech will sharpen attention on the release of May employment data on Thursday, with any hint of weakness in either employment creation, or a rise in the jobless rate likely to fan bets on a further cut in interest rates in July.

Financial markets have already priced in two more cuts before the end of the year, with some expecting still more policy further action in 2020.

Some economists see a possibility that the RBA will deploy unorthodox policy measures for the first time in its history.

Westpac Chief economist Bill Evans said on Wednesday that global investors were weighing the still-distant possibility of quantitative easing in Australia

European investors were of the view that QE should only be adopted when a credit crisis had emerged, he said.

“It should not be adopted as a form of stimulus, particularly when the stimulus is aimed at chasing a NAIRU that cannot be known in advance,” he said.

Evidence around the world indicates that NAIRUs are much lower than anticipated, with the US unemployment rate of 3.6 per cent still not generating clear wage pressure, Mr Evans added. “The issue of whether the RBA moves into a ‘QE-mode’ will be a very difficult one for them to consider.”

Rob Mead, managing director and co-head of Asia-Pacific portfolio management at PIMCO, said the RBA would have to be approaching a zero cash rate with recession warnings flashing before seriously entertaining any QE or unorthodox policies.

Any QE-style or unorthodox policies in Australia would need to be particularly nuanced compared to other jurisdictions, given that government bond supply is limited, and the fact that many large superannuation funds and self-managed funds were already chronically underweight on defensive assets, he said.

“So any proposed Government Bond purchase program would hopefully target foreign bond holders in order to try to weaken the Australian dollar,” Mr Mead added.

The Wall Street Journal