How many job losses will satisfy the RBA?

There is a technical economic concept that you should get to know, if you don’t already know it. It’s called the Phillips Curve. And it may be about to change your life.

Basically, it posits an inverse relationship between rates of unemployment and rates of inflation. That is, the lower the former, the higher the latter.

Roughly a year ago, David Norman and Anthony Richards of the RBA published a seminal piece of research that modeled Australian inflation over several decades and concluded that a fairly basic Phillips Curve modified by inflation expectations was the best tool for predicting Australian inflation outcomes. The paper offered a few excellent charts. Firstly, of Australian inflation itself, which shows a distinctly upward trend since the turn of the millennium:

Next is a chart of the various inflationary pressures acting on the economy over time: import prices, labour costs, the output gap and inflation expectations:

As you can see, the trends in unit labour costs and inflation expectations track the path of past inflation quite neatly.

And that was the conclusion reached by the researchers and their modeling. Following are the predictions of four modified Phillips Curve models graphed against actual inflation.

You can see why the RBA concluded that a simple Phillips Curve is the most accurate inflation modeling tool, even accounting for such variables as oil prices.

So, what does this tell us about the RBA’s intentions today? I’m not technically adept enough to build my own Phillips Curve model so I can’t give you an accurate read. What I’ve done instead is chart inflation against the unemployment rate over time:

I’ve circled the periods in recent years when unemployment sank to or below 5%. And you can see again, that there is a strong correlation between the 5% unemployment level and inflation rates above the top level of the RBA band at 3%.

So, what can we conclude about today meeting of the RBA board?

First, in any normal circumstance, it’s a fair bet that the Phillips Curve would be telling the RBA to raise rates today.

Second, if they do so, they have one objective in mind: job losses to quell inflation.

Third, if they don’t raise, it tells you something about how anxious they are about the risks that a new external or internal shock will overshoot their job loss and inflation objectives.

Fourth and more long term, if we get through current global ructions (which I sorely doubt), you have to ask yourself, just how high will rates have to go to keep unemployment at or above 5% and inflation within the band?

Houses and Holes
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  1. Mate,
    Interest rates were 9.6% in 2008 at the big 4. They have to go back to those levels… And this means 2% of increases to come.
    If they don’t raise interest rates your superannuation goes puff like a cloud of smoke because of inflation. When you retire you’ll have 1 million $ in super… Which at the time will be just enough to take a trip to Alice Springs.

    Are you sure you don’t want higher interest rates?

    • Real rates are already much closer to that level owing to unilateral bank hikes.

      The likelihood of them getting there again is very slim in my view.

      Housing will crack first.

      • I imagine the cash rate will soon be reduced. However, I can’t help but think that this isn’t a good thing. For one, it will prop up the house prices (even if they are still falling, they’d be falling less than with higher interest rates). It’s easy to see how this played out in the UK and US. UK have had about a 20% decline of 4 years and the US about a 30% decline over 5 years. Both those markets are capitulating again after small rises due to lower interest rates and other govt support. However, those saving for a house in those markets have been sacrificed for those indebted. This is disgraceful in my opinion but I will not be surprised to see the same here.

    • I think that previous anchors may not be a apt representation of future.

      Firstly, IMHO, they overshooted the last time (although GFC came in handy to take the blame)

      Secondly, 9.6% may become just too much for our indebted average national household. Remember, debt has kept on increasing since rates last saw the day of 9%ish, and more aptly has accelerated at very rapid paces in some instances.

      We are too indebted for our own good where the only choices left are to undertake deleveraging ourselves or if we are too arrogant to do it, let the RBA do the heavy lifting for us (Causation, it’s the mining boom this time)

  2. How many job losses will satisfy the RBA?

    Or in Gittins-speak, how much labour needs to be “freed up” to “make room” for the inflationary pressures coming from the mining boom.

    FWIW, I think the RBA is (or at least should be) worrying more about domestic weakness than external events.

    • I heard a new word that could be added to the Official MacroBusiness Glossary (OMG!) – “BullSweet”, which would cover what Gittins! “says”.

      • “BullSweet” …the act of promoting the hi”
        to a knee- ,by adding a wee”
        Gift wrapped as a Lolly,and ,often served by coffee ,and read like tea…

  3. Considering the doom talk coming from the retail sector it is surprising that the unemployment rate continues to resist the script. If their calls of impending job losses are borne out the RBA may be relieved of a tough call.

    • The unemployment rate is indeed a mystery. Employment growth has flatlined this year, but by any measure, unemployment is still very low. But as they say, unemployment is a lagging indicator…

      • It’s not much of a mystery when the Government considers 1 hr of paid work as employment. It’s been said here and other places; how do we have 2.5 million under or unemployed people yet still have 5% unemployment. Statistical BS.

        • Right on Johnno. When Mission Australia and The Salvation Army state that the number of people registering with them in order to claim bebefits from CentreLink has been, and still is increasing as of July 2009, by a large number every month sisnce then. It is obvious that unemployment is on the up and up.

    • +1.

      Add to that job losses in the building sector and the RBA may get it’s 5% unemployment rate


  4. This is a very interesting topic, but I don’t agree with the conclusions at the end here, as you’re missing the correlation with interest rates.

    Looking at these charts doesn’t tell you when the RBA chooses to raise rates, and so it doesn’t tell us that the RBA should raise rates today. When unemployment goes below 5% maybe that does result in higher inflation, but didn’t the RBA know about that last year when they were quickly raising rates? So with unemployment stable at 4.9%, don’t you think that maybe they feel they’ve already done enough?

    Is there anything magical about 5%? What about 4.5%? What about the rate of change of unemployment? Which of these three is the bigger driver of *interest rates*? How about growth (or contraction!) in broad money?

    So in other words, I don’t think their bias is definitely towards tightening today simply based on the Phillips Curve (as in your third conclusion), and so we can’t conclude that if they don’t tighten, then they must be anxious.

  5. Too easy, there’s no formula that can predict inflation! See oil prices in the last 4 years. But history never repeats. The new normal is here, a new normal of subdue credit growth and high dollar.
    The reason Australia has had high inflation in the last decade is very low productivity, an undervalued dollar and unsustainable credit growth.

  6. The premise of this article is spot on IMO. The RBA does indeed use unemployment as a weapon to discipline inflation in accordance with the concept of a NAIRU.

    Maybe in forecasting them sitting on the sidelines today, I’ve underestimated just how seriously these unelected, undismissable (by the public) government officials take their belief that the best way to keep inflation in check is through the maintainence of a permanent pool of unemployment and disadvantage.

    • Thanks for sharing that, The Prince. I had always maintained that we would see rates cut before they were raised again. Looks like I might be wrong if Keen is correct.

      FYI, my FB post earlier after CPI numbers were out was a troll on my housing bull/investor mates which ended up backfiring, LOL.

  7. Ah, the old Phillips Curve myth…

    “There’s no question now that inflation is a monetary phenomenon. It happens when the central bank lets the money supply grow too fast, and there are too many dollars chasing too few goods.

    Economic growth doesn’t cause inflation. If anything it helps reduce it. When there’s more goods out there competing for those dollars, it offsets growth in the money supply.”

    • “There’s no question now that inflation is a monetary phenomenon. It happens when the central bank lets the money supply grow too fast, and there are too many dollars chasing too few goods.”

      Not entirely correct.

      A country can engage in a war, and have its productive base destroyed.

      Monetary base can stay constant, and inflation will still occur.

      Now, this is an outlying example, but say a reward structure that sees people move from productive work to unproductive work, say from manufacturing to becoming a real estate agent, because “ZOMG!!, How to make a Motza !!” and we have the same thing.

      • Fair call….I was more arguing against the claim that when an economy gets “too hot” inflation is automatic. An economy that is growing through natural means (not money supply increase) will not cause inflation.

        Therefore economic growth and the subsequent fall in unemployment does not cause inflation

  8. H&H,
    looking at your chart of inflation vs. the unemployment rate over time I can see some similarities between mid 2008 and the present i.e. both curves start diverging. I saw some technical analysis for the US that compares the time before Lehman went belly up and the present and it’s strikingly similar. My bet is that RBA will stay put for now but we will likely see the unemployment going up soon. At the same time it’s unlikely that they will reduce the interest rates as it would send a wrong signal to the housing market.

  9. I believe what your saying H&H, and my view is that we’ll get option 3 (no rate rise) as much as the algo tells them to raise. My belief is the fragility of the non mining sectors is the principle that will guide their decision.

    If they raise we’ll see in a few quarters how that played out, but I expect not good.

  10. Here’s a thought going through my mind at the moment:

    The main thing the RBA are worried about is the mining boom. This obviously translates to high wages for those in the industry, unless there is a sufficiently large pool of people available.

    I think the RBA are looking to get people out of property building sites, and into mining sites.

    The best way to do this is to make it uneconomical to build property, which can be done by hiking rates (costly loans), and making it more expensive to build property than you can sell it for.

    People leave the building industry en masse and transition into the mining industry, as that’s where the jobs are, keeping a lid on wage inflation and keeping the housing stock low, so a double win for the RBA.

  11. When and why don;t teachers, police and nurses go on massive strike to get a piece of the pie – country will buckle and pay you in a month – that;ll teach RBA about inflation.