Australian unemployment and RBA policy

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By Michael Knox

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Chief Economist and Director of Strategy

Date posted:

13 April 2015, 1:15 PM

We recently showed how falling US unemployment meant that the Fed would start increasing interest rates later this year. When unemployment is low, wages growth increases. When wages growth increases, core inflation tends to rise. The Central Bank then reacts by increasing interest rates to slow growth.

In the US, unemployment is falling. Falling unemployment therefore suggests that the Fed will increase rates.

When unemployment is high, wages growth slows. When wages growth slows, core inflation tends to fall. The Central Bank then reacts by reducing interest rates to increase growth. In Australia, rising unemployment therefore suggests that the RBA will cut rates.

The US and Australia are in different employment cycles. As a result of a Fed Funds rate near zero and quantitative easing, US unemployment is falling. In Australia, interest rates are well above the zero bound. The RBA was worried that there might be a possible wages breakout caused by the mining construction boom. It therefore kept a firm hand on monetary policy. This has resulted in an extended growth recession. A growth recession is what happens when growth in the labour force is faster than growth in employment. Unemployment goes up.

In Chart 1 above we can see the level of Australian unemployment since January 2003. The period from 2003 to 2008 saw falling unemployment. Australian unemployment found a low of 4.1% in March 2008. That low in unemployment has never been tested again this century.

In both the US and in Australia, the low in unemployment was followed by the global financial crisis. The global financial crisis then caused a surge in unemployment. In both the US and Australia, unemployment peaked and then fell. US unemployment kept falling. Australian unemployment declined from 2009 to 2011. Then it rose again.

Australian unemployment made a low of 5.0% in 2011. It then rose slightly and then fell again to a low for 2012 of 5.1%. Since that time, unemployment has continued to rise. Australia has been in a growth recession since 2012. This growth recession is not the result of circumstance. It is the result of policy. The policy was to contain inflation.

In Chart 2 above, we see our model of Australian core inflation based on Australian unemployment. In our previous issue, we talked about the "natural rate" of unemployment. We noted that in a sense this is used by the Federal Reserve, the "natural rate" of unemployment is the level of unemployment that allows the Central Bank to achieve its target rate of inflation. We said that the current "natural rate" of unemployment in the US suggests that a 5.1% level of US unemployment allowed the Federal Reserve to achieve its target rate of 2% inflation.

Most of the discussion of where the "natural rate" of unemployment is in Australia has centred around the long term average rate of unemployment. In Chart 1 we can see Australian unemployment on the monthly basis since January 2003. The average level of Australian unemployment over that period is 5.24%. The median is 5.2%.

So in practice, the "natural rate" of unemployment is thought to be somewhere around 5.2%. When unemployment falls through this level, inflation can be expected to accelerate some months later. This means that if the RBA wants to stabilize inflation, it will start to look towards cutting interest rates as unemployment rises above this level.

What our model in Chart 2 tells us is that each 1% rise in unemployment should reduce Australian inflation by around 0.9%. Currently, inflation is tracking around 0.2% higher than our model might suggest based on long term average unemployment.

Remember the "natural rate', as we are using it in the Australian case, is the level of unemployment which stabilizes core inflation at 2.5%. Based on our model, we estimate this as 0.2% above the long term average of unemployment at 5.2%. This means we think the current "natural rate" of unemployment in Australia is 5.4%.

Right now Australian unemployment is 6.3%. This suggests that inflation should be falling. Our model of Australian core inflation (Chart 2) suggests that this is exactly what should happen. The current high level of unemployment should result in a level of core inflation for the March quarter of 1.9%.

This 1.9% would be below the lower end of the RBA's 2%-3% band. The RBA should react to this low inflation number by cutting the cash rate at the May RBA meeting.

This downward pressure on inflation and the Australian cash rate should continue as long as Australian unemployment remains high. So far, nothing that the RBA has done in the past year has been enough to make Australian unemployment fall.

Even if the RBA cuts rates in May, this should not be the last time it cuts.

More information

I was interviewed by Ross Greenwood on the topic of the RBA and interest rates on the Macquarie Radio Network. You can listen to the interview at www.2GB.com

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