Australia’s labour market strength is starting to fade. A weaker labour market will help to cap wage growth and should over time help to bring inflation back inside the RBA’s 2-3% target. A weaker labour market will pave the way for the RBA to start cutting the cash rate, but the initial rate cut is still many months away and could easily be pushed further away if the softening labour market takes an extended time to bring annual wage growth down below 4% y-o-y.

The inflation reduction maths is relatively simple. To get the current inflation rate around 4% down sustainably within 2-3% target, ideally back to averaging around 2.5% for an extended period, annual wage growth can run around 3.5% but only if accompanied with annual labour productivity of 1% or more. At present wage growth is running 4% (perhaps a little higher in Q4 2023 when the wage price index report is released on Wednesday) and labour productivity is running -2% (that may improve to -1% when the Q4 GDP report is released in March).

While productivity is so weak, wage growth is running much too high to bring down inflation to 3% or less. High wage growth has been fostered mostly by the tight labour market, too little supply of labour relative to strong demand. High wage growth has also been caused by changes to regulations relating to the labour market plus several very big wage increases in areas such as the minimum wage, the child and age care sectors and most recently in the ports. These big wage increases have mostly been granted without any requirement for higher productivity.

The problem of too little labour supply relative to demand may be starting to change. In January the unemployment rate rose to 4.1% from 3.9% in November. That was the highest unemployment rate in two years, but it is worth keeping in mind that the unemployment rate has been tracking unusually low since the period of peak covid lockdowns in 2020 and 2021.

Through 2023 the unemployment rate was in a low range of 3.4% to 3.9%, low levels not seen in 50 years and back then only briefly. Just by comparison, in the decade before the start of the covid pandemic, which at the time was considered a period of low unemployment, the average unemployment rate was 5.5%.

The underemployment rate is also a good measure of the relative tightness of the labour market, measuring those in employment who would work more hours if offered. In January, the underemployment rate rose to 6.6% from 6.5% in December. The underemployment rate was at its lowest point in the second half of 2022, mostly just below 6% before lifting to mostly just above 6% through much of 2023. Like the unemployment rate, the underemployment rate was much higher in years before covid, mostly above 8%.

The unemployment rate readings and underemployment readings over recent months indicate that the exceptionally tight and unsustainable labour market conditions that followed the end of covid restrictions are becoming less tight. Conditions are still tight, however, if based on the prevailing unemployment and underemployment rates prevailing in the decade before the covid pandemic.

In short, the unemployment and underemployment rates need to rise more to play an effective part in capping and starting to reduce wage growth. It will probably take an unemployment rate of 4.5% or more, plus an underemployment rate above 7% to ensure that annual growth in wages glides down to 3.5% or less by the middle of next year. This assumes that the high wage growth problem will not become worse in the near term.

The Q4 wage price index out this week needs to show annual wage growth around 4.1%, or less. If it is higher, it implies the need for an even weaker unemployment rate and underemployment rate, which even with a softening labour market may take many months to show.

Similarly, there needs to be convincing evidence that labour productivity is lifting strongly enough. The RBA has penciled in 3% y-o-y change in labour productivity in its forecasts for the middle (Q2) of this year. That is a big lift from -2% in Q3 2023, but without that increase wage growth in the first half of this year at 4%+ will blast away any hope of inflation receding below 3% by the middle of next year.

It is a case of simple maths – inflation is the product of wage growth adjusted for labour productivity – and it shows why it is wishful thinking to expect the RBA to start cutting the cash rate until it has sufficient evidence and reason to support its forecast of inflation returning to target range by the second half of next year.

The evidence the RBA needs in terms of weaker labour market conditions, wage growth sliding below 4% and sharply improving labour market productivity will not show until mid-September at earliest and may take much longer. The likelihood of a rate cut in late 2024 is small, much smaller than the market is factoring in our view.