Economic growth in many parts of the world and including Australia looks set to move further above long-term trend through 2018 and in to 2019 unless restrained by tighter monetary conditions. Central banks are taking their time tightening monetary policy. Indeed, monetary conditions are still very easy and growth accommodating around the world, even in countries where central bank official interest rates are rising and unconventional monetary easing measures are being reduced or reversed. One marker of how easy monetary conditions remain is that central bank official interest rates still almost all sit below annual inflation rates – well below in the case of the European Central Bank with a -0.40% official deposit rate against an annual inflation rate of 1.4%.
The main reason why central banks are moving painstakingly slowly is that strong economic growth is not yet priming higher inflation. In many countries inflation remains unusually low for this stage of the growth and employment cycle. Central banks are allowing economic and employment growth to run stronger for longer than they have in the past based on a view that special factors are allowing employment to run hot without generating an inflationary lift in wages.
It is fair to say that although special factors seem to be in play holding back wages growth the nature of these special factors is in the realm of hypothesis rather than proven fact. One special factor put forward is the impact of changing demographics. Highly-paid baby boomers are reaching retirement age and it is argued are being replaced by lower-paid younger workers. Another variation is that baby-boomers are retiring later and seeking part-time positions in many cases adding to the supply of labour (the labour force participation rate).
Another special factor put forward is the casualization of more parts of the work force keeping wage demands in check. In Australia, very strong immigration is another factor viewed as helping to add to the supply of labour. Also, the fall-out from the end of the mining investment boom it is argued led to many high-paid jobs being lost and those laid off often finding lower-paid jobs. Also, high employment growth in comparatively lowly-paid jobs in personal services is occurring at a time when relatively-high paid jobs in areas such as financial services are becoming scarcer.
These special factors provide plausible cause for how Australia managed to register extremely strong employment growth in 2017 – up 3.3% y-o-y or 403,100 and with full-time employment up 3.7% y-o-y or 303,300 – booming demand for labour while wages rose by only 2.0% y-o-y (latest data for Q3 2017). Extremely strong demand for labour through 2017 was met by extremely strong supply. The labour force participation rate rose from 64.8% in December 2016 to 65.7% in December 2017. As a result of this additional labour supply strong employment growth led to only a modest fall in the unemployment rate from 5.8% in December 2016 to 5.5% in December 2017.
The rising labour force participation rate is helping to ensure that labour market capacity is dwindling unusually slowly as the economy strengthens. The special factors causing the rise in labour force participation may continue helping to delay the onset of faster wages growth. The RBA is assuming in its forecasts that labour force participation will continue to rise; that the unemployment rate will fall only slowly and that it will still be some time before wages growth gathers momentum. The RBA’s views about the labour market provide one important reason why it sees annual inflation staying subdued through 2018. In turn it provides the key reason why it feels it does not need to respond in the near term with a higher cash rate to signs of strengthening Australian economic growth or the moves of peer central banks overseas starting to lift official interest rates.
Essentially the RBA is playing a waiting game. It is waiting to see how long the special factors keeping wages growth low persist. It also knows that even if these special factors stay in play they will not be enough to prevent the labour market tightening to the point of pushing up wages medium-to-longer term. At some point, a higher inflation outlook will push the RBA to start lifting its cash rate. The issue is when will that higher inflation outlook come in to play?
Our view is that it is highly unlikely that higher inflation will show in the Q4 2017 CPI due next week, or the Q1 2018 CPI due in April. By mid-2018 we do expect the first signs that the tightening labour market is spilling over in to higher wages growth. We also expect that the Q2 2018 CPI will be the first not so low inflation report. We expect the RBA’s waiting game to be over by August and that it will deliver its first 25bps cash rate hike at its early August policy meeting.