MNI POLICY: RBA Soft Landing Banks On Productivity Improvement

The Reserve Bank of Australia is betting that growth in productivity will return to pre-pandemic levels and employee inflation expectations remain contained as it considers whether it needs to hike rates again while it steers the economy towards what it hopes will be a soft landing.

Though the RBA believes the country’s low wage growth sets it apart from peer economies struggling with strong services prices, this situation will only persist if productivity returns to 2019 levels, an assumption which it has factored into its forecasts for inflation to fall back to the 2-3% target range by 2025.

RBA Governor Philip Lowe told the House of Representatives Standing Committee on Economics last Friday that productivity growth represented the biggest challenge to the Australian economy, alongside services inflation and China’s slowdown. (See MNI BRIEF: Services, Productivity, China Biggest Risks - Lowe) MNI has reported on the stickiness of services inflation, particularly market services, which has been affected by a dramatic fall in post-Covid productivity. (See MNI INTERVIEW: Poor Productivity Feeding Australian Inflation)

UNIT LABOUR COSTS

Productivity overall has not grown since 2019, excluding the pandemic years, which the RBA ignores due to its distorting effect on its models. However, growth in unit labour costs– the cost of labour adjusted for productivity – is running hot, driving increased market services inflation and contributing to strong services price growth.

Quarterly CPI data released July 26 showed services prices jumped 6.3% over Q2, the strongest gain in over 20 years and evidence that domestic sources of inflation remained strong, despite the 1pp drop in the headline rate over the quarter to 6%. Following the RBA board’s Aug. 1 decision to hold rates at 4.1%, Lowe noted many services “are rising briskly." Despite this, former RBA staffers told MNI the board will likely hold the cash rate steady unless inflation surprises to the upside.

The RBA believes that, while the transmission mechanism in this case is perhaps not as direct as in other sectors, the higher restrictive cash rate will eventually pull down market services inflation as the economy reaches a better balance of supply and demand, particularly in the labour market. The bank has assumed an increase in the unemployment rate to 4.5% by 2025 from its current 3.5%.

The Reserve expects wages to rise further over the second half to peak at 4% growth before declining over the next two years – an important factor that will moderate unit labour costs. However, this hinges on the productivity recovery and on inflation expectations remaining grounded as employees enter wage negotiations, MNI understands.