Monthly Archives: May 2022

It (still) all comes back to productivity

Amidst all the discussions of this week’s interest rate rise and the outlook for inflation, wages and growth, one crucial factor has been largely overlooked: productivity.

It’s an ugly word and can be very tricky to measure.

But it is likely to play a crucial role in how high interest rates go and how well-off we all become.

Productivity is basically a measure of how much is produced for a given level of input (labour, capital and other resources).

When he was Treasury secretary, Ken Henry regularly referred to productivity as one of the three Ps crucial to growth (the others being population and participation).

Productivity is especially important in a high-inflation environment like we have right now. The more that can be produced using a given amount of labour and capital, the cheaper it is to produce.

If there is sufficient competition, this will tend to put downward pressure on prices.

The big problem is that for the 25 years productivity growth in Australia has been mostly weak.

Analysis by the Australian Bureau of Statistics shows that in that time both labour productivity and so-called multifactor productivity (that is, productivity including labour, capital and everything else) has mostly been below 2 per cent.

The last time it reached above that was in 2014-15.

This brings us to the Reserve Bank of Australia’s latest assessment of the economic outlook, which came out on May 6.

In it, the central bank lays out its central case for how it thinks things will turn out.

Broadly, it expects inflation to rise to 6 per cent by the end of the year and only gradually ease back to 3 per cent by mid-2024.

It thinks unemployment will remain low (3.5 per cent), forcing wages and other inducements like bonuses and overtime payments to accelerate to around 5 per cent by mid-2024.

This will support household consumption and growth.

This is what the RBA thinks is the most likely scenario.

But the central bank’s quarterly outlook always includes a section that looks at all the things that could go wrong.

Right now, it is quite a long list – another serious COVID-19 outbreak, ongoing disruptions to global supply chains and tumbling house prices, to name but a few.

But one of the crucial unknowns is productivity.

If it improves significantly, inflation could ease more quickly and real incomes (adjusted for inflation) could grow, boosting prosperity.

There is some cause for optimism here.

Business confidence has increased in recent months and firms are ratcheting up their investment plans. Capital investment has been the most important driver of productivity growth in the most recent cycle, according to the ABS, so the increased willingness of businesses to buy new equipment and technology could deliver an important productivity boost.

But there is ample scope for things to go wrong, as the RBA has acknowledged.

“It is possible that some of the recent changes in spending and production patterns are long-lasting and that these constrain the efficient allocation of resources and, in turn, productivity,” it said.

If that turns out to be the case, then “any given rate of growth could be more inflationary than before the pandemic”.

And if wages increase in the absence of an improvement in productivity, the consequent boost to household spending will likely result in “inflation being sustained at a higher rate than currently anticipated”.

That would inevitably mean that interest rates have to go higher for longer.

So boosting productivity will be key if the nation is to avoid high interest rates and cost-of-living pain.

There are plenty of things that governments can do to help achieve this, like ensuring a welcoming environment for investment (local and international), encouraging greater workforce participation through measures like improving access to affordable child care and investing in education.

For the past decade, progress on any of these has been woeful, and in several cases has gone backwards.

Whoever wins the election needs to make enhancing productivity a top priority.

Our future prosperity depends on it.

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Plenty of sting in RBA tale

Hopes that it may only take a moderate lift in interest rates to calm inflation have been dealt a blow by the Reserve Bank of Australia.

While the RBA Board’s decision at its May 3 meeting to raise the cash rate by 0.25 of a percentage point had been widely anticipated, much more interesting – and worrying, if you happen to be a borrower – is what RBA Governor Philip Lowe and the RBA think is in store for the country over the next couple of years.

Like a pulp fiction mystery author, Dr Lowe left it until two-thirds of the way through his monetary policy statement to make remarks that will make mortgage holders across the country nervous.

After offering some reassuring words about an expected eventual easing in inflation to within the central bank’s 2 to 3 per cent target band, the RBA Governor then slipped in the metaphorical sucker punch.

He warned that the RBA expects headline inflation – currently at 5.1 per cent – to hit 6 per cent this year (and underlying inflation 4.75 per cent) and not moderate to around 3 per cent until mid-2024. That is two whole years away.

The real kicker came in the Governor’s next sentence: “These forecasts are based on an assumption of further increases in interest rates”.

So, barring a highly unlikely plunge in inflation in the near-term, several more interest rates rises are on the way.

While no-one, including the RBA, knows how high they will need to go, the RBA’s worrying language surely opens the way for the cash rate to hit 2.5 per cent or more.

The particular twist in this tale is that the RBA is detecting signs of a long-awaited acceleration in wages.

While this will be good news for millions of wage earners who for the past decade have had to get by on stagnent salaries, it suggests that the domestic demand pressures contributing to inflation are unlikely to ease any time soon.

A lot will be riding, instead, on improving global energy and food supplies and unglogging supply chains and clearing shipping backlogs.

For that, we all better hope that Ukraine war does not spread and that our vaccines can handle future COVID-19 mutations.

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