Post-pandemic investment surge will help to grow the economic pie
There are signs productivity growth may be coming to the rescue for an inflation-battered nation. Will it lead to interest-rate cuts?
The Reserve Bank continues its tough talk about slaying persistent inflation, yet it has been holding interest rates steady since last November. After meeting on Tuesday, the central bank’s board declared it remained “resolute in its determination to return inflation to target and will do what is necessary to achieve that outcome”.
Are they softening up borrowers for more pain? Or trying to give debt junkies and the cashed-up, like governments and baby boomers, a heads-up: Ease off on the spending because demand is still running ahead of supply, which is keeping up the pressure on prices and hurting everyone?
The path ahead is uncertain, the board said in its policy decision statement, and so it is “not ruling anything in or out” on what it will do next. Few in the private sector envy the task facing the board amid the economic fog and community anxiety. Inflation is hitting us all, but not equally.
Plus the RBA has only one tool, setting the cash rate. As its assistant governor Christopher Kent has explained, monetary policy operates mainly via the “cashflow channel”.
“A rise in the cash rate leads to higher interest payments for those who have debt, reducing the income borrowers have to spend on other things, leading to slower growth of demand and ultimately a decline in inflation,” Kent said in a speech last October.
Demand, demand, demand.
We don’t hear about boosting supply, mainly because that’s not the RBA’s job. That’s the task of governments and businesses, and the shorthand way we talk about improving supply in the policy debate is about boosting productivity growth.
This is the missing ingredient in the inflation story and it explains much about our economic circumstances. As the RBA board said the other day, “Productivity growth needs to pick up in a sustained way if inflation is to continue to decline.”
Productivity is a measure of how much is produced divided by the inputs. We usually speak about it in terms of how much labour is used to produce a good or service. The higher we can get productivity growth, the harder we can drive our economy and raise our living standards.
If our productivity growth is low, or zero as it has been for some time, then we generate inflation above the RBA’s target (a midpoint of 2.5 per cent) at relatively low rates of economic and wages growth. That has been our experience. One rule of thumb officials frequently cite is that if we have productivity growing at 1 per cent a year, we can sustain wage growth of 3.5 per cent and keep inflation in check.
While in Australia wage outcomes, the main driver of inflation over time, have not been as extravagant as in other countries such as the US and Britain, the RBA is watchful.
“Wages growth appears to have peaked but is still above the level that can be sustained given trend productivity growth,” the board warned this week.
In the recent March quarter national accounts, annual growth in unit labour costs (the cost of wages and benefits to produce one unit of output) was 5.8 per cent; a year earlier it was 7.4 per cent. Progress of sorts. The Fair Work Commission’s decision to grant a 3.75 per cent increase in the minimum wage was widely applauded by economists, who were expecting a rise of around 4 per cent.
“We think the RBA board will have welcomed the FWC decision behind closed doors,” Commonwealth Bank head of Australian economics Gareth Aird said this week. “The wages story in Australia should not be a problem for the board in restoring inflation back to the target band provided that productivity growth lifts.”
There it is again. The porch light has been on for years, waiting for decent productivity growth. It’s true that the pandemic and its tail of data carnage has made measuring productivity growth, difficult at the best of times, even more arduous. People are cautious.
This week we got a sense of where Australia sits on a global ladder of 67 nations from the long-running World Competitiveness Yearbook, run by the Swiss-based Institute for Management Development, which combines hard data and the views of business executives. Our economic performance is seventh (up from 10th last year) due to international trade, high commodity prices, population growth and a resilient labour market.
Australia’s overall competitiveness rose to 13th (from 19th), but we’re being held back by poor productivity, a narrow production base, staggeringly woeful level of entrepreneurship, slow uptake of digital tools, high office rents and reliance on income tax.
The yearbook’s local partner is the Committee for Economic Development of Australia. The think tank’s senior economist Melissa Wilson noted poor perceptions of the efficiency of our large corporations (ranked 52nd) and fall in workforce productivity in the latest survey (48th).
“The lack of productivity growth remains a challenge if we want to maintain our living standards into the future,” Wilson said. “Both business and government need to do more to address this.”
An explanation for poor productivity growth in recent years has been that a mass of younger, less educated or less experienced workers have flooded into a strong labour market. But new research from RBA economists suggests that may not be the case.
A paper by Angelina Bruno, Jonathan Hambur and Lydia Wang presented last week to an ABS-RBA conference on human capital, found there was an improvement in labour quality over the four years from mid-2018 and that without this rise productivity growth would have been lower.
“At least based on standard metrics, human capital in the labour force increased over the Covid-19 period, rather than declined as some have argued,” the RBA authors concluded.
“This would have contributed to productivity growth, rather than subtracted.”
Some economists believe a sustained lift in productivity growth is in the pipeline due to strong and prolonged business investment post-pandemic. A lot of action has occurred outside of mining, which is in a capital and productivity slump.
EY’s chief economist Cherelle Murphy notes the continued transformation of the economy is evident in a strong rise in machinery and equipment spending “to fit out warehouses and data centres showcasing the increase in online shopping and AI investment”.
Since the pandemic, productivity growth has essentially been flat. But within the market sector it is up by 2.8 per cent.
“The implication is that solving the productivity ‘challenge’ in the economy sits with the government looking for policies that boost output per worker within the public sector,” CBA’s Aird said earlier this month. “The private sector is doing its job on the productivity front.”
As he wrote this week ahead of the RBA’s meeting, business investment lifts capital deepening, where the capital per worker is increasing in the economy. “In turn this improves measured productivity, that is output per hour worked,” Aird said. “But the process takes time.”
Westpac senior economist Pat Bustamante this week shed light on an important piece of the inflation and interest rate puzzle that emerged from the recent national accounts. He pointed out that unit labour cost growth, as previously mentioned a measure of the domestic cost base for businesses and key driver of underlying inflation, is now 2.9 per cent (in six-month annualised terms, a metric that gives you a more recent pulse).
That’s below the pre-pandemic growth rate, when core inflation was 1.5 per cent. And vexed central bankers were confronted with consumer price growth that was too low!
Bustamante says the moderation in labour costs has been more pronounced in the non-mining sector of the economy, particularly in the industries at the forefront of the consumer-led slowdown in spending, where discretionary service providers have been unable to pass on higher costs to customers.
“Here, the impetus to reduce costs and become more ‘productive’ has been the greatest,” he says, adding the significant step down in labour costs growth will be sustained after the “benign” FWC pay decision.
Bustamante is not surprised that analysts missed this development. “The focus has been on the demand side of the economy and whether policy settings are restrictive enough to bring demand and supply into better balance,” he writes.
“However, as we have been saying for some time, the supply side of the economy is not static or fixed. The supply side continues to respond to the ripple effects of the pandemic, and the ramp up in investment in intangibles (such as computer systems, digitalisation of processes, updating digital storage) and capital goods more broadly.”
As an example, the Westpac senior economist uses last year’s population growth, when the number of residents grew by 650,000, with net overseas migration of around 550,000. Given the speed and extent of this increase, businesses were unable to use all this labour supply as efficiently as possible – the capital such as machines, IT systems, infrastructure and digital networks required all lagged the increase in labour supply.
“As the capital stock catches up, businesses will be able to use this record boost in labour supply more efficiently,” Bustamante argues. “This will continue to increase labour productivity which reduces the effective cost of labour (or unit labour costs) as it means more can be produced with the same resources.”
The bottom line is a better result on labour cost growth and underlying inflation, with the latter by this time next year at 3 per cent, the top of the RBA’s target band. The danger, as Bustamante sees it, is that “a too narrow focus on the demand side of the economy may see us wandering off the narrow path” of avoiding a recession that Bullock now says is “getting a bit narrower”.
“If policy remains too restrictive for too long, we may slow demand too much given the recovery in supply,” Bustamante says. “If this occurs, we could be in a situation where we undershoot the inflation target.”
Officials must avoid that disaster, as it would mean more pain than was necessary, for so many, to get the inflation job done.
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