What happened to the NAIRU?

The Reserve Bank has put itself in the spotlight after raising the cash rate at ten consecutive meetings since May last year. It comes at a time when inflation has reached its highest level in three decades. Reserve Bank Governor Phillip Lowe has raised concerns of a wage-price spiral, but are these concerns valid?

In his press release after the meeting at the beginning of February, as part of his explanation for the rises, Governor Lowe explained:

“Wages growth is continuing to pick up from the low rates of recent… due to the tight labour market and higher inflation. Given the importance of avoiding a prices-wages spiral, the Board will continue to pay close attention to both the evolution of labour costs and the price-setting behaviour of firms in the period ahead”

The logic behind this statement - that greater bargaining power for workers when unemployment is low results in wage demands that increase business’ costs which need to be passed on to consumers - is one that has been accepted as gospel in the economics profession since it was conceived and dubbed the NAIRU (non-accelerating inflationary rate of unemployment), but recent experience has caused economists to call that long-standing assumption into question.

According to business surveys conducted by NAB and data from the ABS, the relationship between wages and labour constraints has not been significant since 2013.

The trouble is that fundamental to the NAIRU is an assumption that increased bargaining power not only can, but will translate into actual demands for increased wages and new, higher-paying employment agreements. This was the case in the 1970’s when the theory was being formulated, but much has changed in the 50 years since.

In 1976, just over half of all workers were union members. In 2022, that figure was 12.5%. During the second half of the 80’s – as far back the ABS records go – there were an average of 402 industrial disputes every three months. The most recent equivalent period of data on record shows just 33 disputes occurred.

A recent Treasury Working Paper by Jonathan Hambur estimated that labour market concentration pushed down wage growth by a little under 1% from 2011 to 2015.

He notes that:

“A key driver of the increased impact of concentration appears to be declining firm entry and dynamism, as it has meant that incumbents faced less competition from new entrants”

Our current approach to managing inflation can be summed up by the famous quote from Milton Friedman, “Inflation is always and everywhere a monetary phenomenon”. The implication is that no matter how inflation is caused, it can be resolved by returning the money supply to a new equilibrium given the supply conditions.

In contrast, former chief economist of the IMF Olivier Blanchard recently said “Inflation is fundamentally the outcome of the distributional conflict between firms, workers and taxpayers. It stops only when the various players are forced to accept the outcome”.

In 1983, the Hawke Government signed a deal known as the Prices and Income Accord with the trade unions to promise wage restraint. The deflationary effect was almost immediate and set the stage for the ‘great moderation’ of low inflation through the 90’s and 2000’s.

As Dr Chris Wright of the University of Sydney put it:

“agreement by unions to restrain wages to help contain inflationary pressures formed the basis of Accord Mark I… Economists broadly agree that the Accord was successful in fulfilling its initial objectives to contain wage inflation, real wage costs and industrial disputation”

When inflation picked up in 2022, the Albanese Government identified that it was driven by energy prices that were not caused by domestic supply issues - given Australia’s LNG exports were the highest on record - and responded by implementing price caps. The RBA noted in its February Statement on Monetary Policy that “wholesale electricity and gas prices declined in response to the announcement of the temporary price cap”, although inflation remained outside the RBA’s target range.

In both scenarios, either labour or capital was attempting to expand their piece of the economic pie at the expense of the other. In both scenarios, the successful response was to force or convince them to relax their demands. In reality, the NAIRU has not disappeared, it is simply no longer relevant in our modern economy, given the regulatory restraints on workers’ bargaining power that have been implemented during the monetarist era. In light of this understanding, our debates about monetary policy should shift from an exercise in answering the questions: “how fast?” and “to what degree?”, to a thoughtful discussion about how bargaining power on both sides of the distributional struggle impacts prices, and considers using the right tool for the right job.

Treasurer Jim Chalmers has commissioned a review of the RBA, and its terms of reference indicate that our monetary policy framework is on the table.

In his essay earlier this year for The Monthly “Capitalism after the crises”, Dr Chalmers’ indicated his belief that during the GFC, our major policy frameworks were “shown to be so inadequate” and “couldn’t explain why investment stalled and growth slowed”. He laments that in the aftermath of these crises, which revealed weaknesses in our economic frameworks, our “mental models for most economic decision-making have been unchanged”. He explained how he intends to develop new frameworks which “put values at the forefront of how our economies work”.

The RBA review is set to submit its final report this month. Then we’ll see how Chalmers’ philosophy translate to real reform.