It is now unarguable that the Reserve Bank’s dubious economic models are driving its monetary policy decisions. Chillingly, if its models are wrong, so have been and will be its decisions on interest rates.
A trawl through the Reserve Bank’s 73-page Statement on Monetary Policy released last Friday will find no reference to the NAIRU, yet its influence is everywhere. Driving monetary policy is the Non-accelerating Inflation Rate of Unemployment, which the Reserve Bank estimates at 4.5 per cent.
Since the Reserve Bank views its primary responsibility as being to prevent inflation from taking off, it sets the cash rate to increase unemployment to its estimated NAIRU.
Yes, that’s right; the Reserve Bank deliberately seeks to drive up the unemployment rate by increasing the cash rate until unemployment hits its estimated NAIRU.
Right now, the unemployment rate is 3.5 per cent. No prizes for guessing the Reserve Bank’s official forecast for the unemployment rate. Yep, it’s 4.5 per cent from around the middle of next year, bang on its estimate of the NAIRU. And the unemployment rate is forecast to remain at 4.5 per cent through to the end of the forecasting period in December 2025.
Perhaps we should be thankful for small mercies. Back in 2018, the Reserve Bank estimated the NAIRU at 5 per cent. If it had retained that estimate, instead of revising it down to 4.5 per cent, its forecasts for the unemployment rate would have been 5 per cent instead of 4.5 per cent.
This slavish adherence to a number generated by an economic model is set to cause needless suffering by vulnerable workers as rising interest rates cost them their jobs.
How ironic, then, that the Reserve Bank’s Statement on Monetary Policy observes that much of the decline in the unemployment rate over recent years has been driven by long-term unemployed people finding jobs?
It’ll be a case of last-on, first-off for these vulnerable people as the Reserve Bank drives up the unemployment rate to its target of 4.5 per cent and keeps it there indefinitely.
Any economic model estimating the NAIRU must rely on historical data. But this data reflects the economic and institutional conditions of the time, which are unlikely to be replicated in the present or the near future.
In the last 15 years the world has undergone the Great Recession of 2008-09 and a once-in-a-century pandemic. The period also coincided with the rise of China’s massive middle class, which has bolstered global savings, exerting downward pressure on interest rates. More recently, Russia invaded Ukraine, causing many commodity prices to spike.
In Australia and elsewhere, union membership among workers has plummeted and workers have not been able to recoup increases in their cost of living through wage rises.
As the Reserve Bank acknowledges, the present unemployment rate of 3.5 per cent is not causing inflation to accelerate, adding that most measures of medium- and long-term inflation expectations remain consistent with the inflation target of 2-3 per cent.
The Reserve Bank expects a pick-up in wages growth through the negotiation of new enterprise agreements and increases in the minimum wage and award wages. But there is still no evidence of a wage-price spiral reminiscent of the early-1980s when union membership was much greater, and the wage-fixing system automatically generated wage rises in response to inflation.
Indeed, the Reserve Bank reports that firms continue to use bonus payments to attract or retain staff and to compensate for cost-of-living pressures. This seems rational behaviour by firms scarred by the pandemic-induced recession and worried about an ongoing economic slowdown triggered by the Reserve Bank’s sharp tightening.
These firms won’t want to bake permanent wage rises into their cost base, especially when the Reserve Bank expects economic growth to slump to its lowest rate outside the pandemic since the early 1990s. While the Reserve Bank’s charter – its governing law – is to achieve full employment and price stability, it has decided that full employment is 4.5 per cent.
Relying on estimates of the NAIRU derived from modelling using old data to decide on the cash rate runs the very real risk of the Reserve Bank tightening too hard and keeping the cash rate too high for too long.
It would be far better to use the NAIRU as a notion and to know it has been reached at an unemployment rate where inflation is not accelerating. That might already be the case right now, at the present unemployment of 3.5 per cent. After all, the Reserve Bank has acknowledged that global supply-chain issues that it has estimated were responsible for the bulk of the inflation have largely been resolved.
The Reserve Bank should maintain its pause on rate rises unless and until it sees evidence of a wage-price spiral. And it shouldn’t rule out the possibility that the next interest-rate move might be downwards as the economy slows to a crawl.
Craig Emerson is managing director of Emerson Economics. He is director of the APEC Study Centre at RMIT University, a visiting fellow at the ANU and adjunct professor at Victoria University’s College of Business.