Houses and Holes yesterday covered a speech by the RBA’s Phil Lowe in which the RBA confessed it had gotten the economy wrong. The conclusion was, rightly, that rates can fall further in the period ahead.
For me, however, the thing that stood out was not just that rates are going lower but that the potential growth rate of the non-mining economy was, or is, impaired for the foreseeable future.
Let me explain.
Back in 2008 Glenn Stevens gave a speech titled “The Directors’ Cut: Four Important Long-run Themes” with one of these themes being the economics of a fully employed economy. Essentially he said that the growth rate of the Australian economy had to slow going forward as the supply of labour slowed, unless productivity increased:
Over recent years, the Australian labour market has been as tight as at any time seen in a generation…
Let’s be clear that full employment is a good thing. It is one of the statutory objectives given to the Reserve Bank in our Charter (though interestingly the authors of the Act never quantified what they meant by full employment, nor for that matter, by ‘stability of the currency’).
But the economics of full employment are different from the economics of trying to get to full employment. This is a simple point, but an important one. When the economy has too much spare capacity – say, in the aftermath of a business cycle downturn – the aim of macroeconomic policies is to push up demand so that it catches up to supply potential. There may be several years in which demand growth exceeds the normal pace as it eats into the spare capacity.
Once the spare capacity has been wound in, however, actual growth in demand and output has to slow, to match the growth rate of potential supply. That growth in potential supply is given by the growth in the labour force, the capital stock and the productivity of those factors of production. Typically we think of ‘potential GDP’ in Australia rising by something like 3 per cent a year, give or take a bit.
This, as my predecessor Ian Macfarlane remarked a few years ago, means that once the reserves of spare capacity are pretty much used up, we should expect to be accustomed to growth rates for GDP starting with a 2 or a 3. There will not be many with 4s or 5s, as we had for some years through the 1990s and earlier this decade. Periods of growth noticeably above about 3 per cent will be roughly matched in frequency and duration by periods below – as we are having now. If we set our aspirations higher than that – if we try for above-average performance all the time – we will just get inflation. That is the economics of full employment.
…The only way the potential growth rate can be lifted is by adding more factors of production – more labour and capital – or raising the growth rate of productivity. Over the long term, the key is productivity. On that front, productivity growth does seem over the past several years to have settled at a lower average rate than we had seen since the early 1990s. This may have several causes, and the experts debate them. But over the years ahead, as a community we must be sure not to let up on our efforts to keep productivity growing. I have no specific policy prescriptions here – only general ones – trying to sustain competition, to keep markets open, to maintain flexibility and so on. But those general values are worth recounting from time to time.
The corollary of this is that with a tight labour market and low productivity growth, the potential rate of growth for the non-mining economy is lower than the long run average.
Phil Lowe’s speech displayed the familial traits laid down for him by Stevens in 2008 and Ian Macfarlane before him when he said:
The overall conclusion from this work is that given the huge pipeline of mining investment and the current relatively low unemployment rate, it is likely that conditions will continue to vary significantly across industries for some time to come. This work also serves as a reminder that improving productivity growth remains the key to strong output growth in the non-mining-related parts of the economy.
This speed limit on growth coming from the employment market at a time of household deleveraging is one of the reasons I have had a jaundiced view on the Australian economic outlook for some time.
But the flip side of the speed limit on growth, or should I say non-inflationary growth, is that if there are capacity constraints within the labour market and if there is a mining boom in your economy then there is a big risk, in the minds of central bankers, that the bidding up of the prices paid for labour in the mining sector leaks into the non-mining economy. The RBA believed this a massive risk because, as I have written many times previously, it was scarred by the 5% CPI print in 2008. So they have been dragged reluctantly to the rate cutting table and now find themselves playing catch up as the evidence has mounted that they have been wrong about the durability of household’s shift to saving.
So the key message for me in Phil Lowe’s speech is that in a non-inflationary environment the RBA recognises the limit to growth that full employment now places on the non-mining part of the Australian economy and that this, along with the obvious revelation that the RBA now recognises that household deleveraging is here to stay, means that even after cutting rates 50 basis pionts this month, they may still be behind the curve.