Interest rates are still rising. So is inflation

High inflation is a key policy issue in Australia. Australian Bureau of Statistics data show inflation in April accelerated.

That means even though we have seen interest rates going up for a year and a half, inflation is not slowing down enough.

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Inflation has multiple components. Goods inflation is still high but the global slowdown is causing it to ease.

But a key influence for inflation, particularly in services, is unit labour costs. Unit labour costs in an economy refer to the cost of the labour it takes to produce one unit of output. So for example, if you produce 10 per cent more in an hour and are paid 10 per cent more per hour, your unit labour cost remains the same because each dollar of labour is getting the same amount of output. But if you get a 10 per cent payrise and do 3 per cent more, your unit labour cost is higher, because even though you’re producing more per hour, each dollar of labour cost isn’t producing as much output.

“Doing more” in an hour is not simply people working harder. Productivity growth can come from having better technology available, more education or more efficient processes at work. Your pay is the wage growth part of unit labour costs.

So when wage growth is going up quickly and productivity isn't going up as quickly, that's when we get an inflation problem - because it mean the cost of producing one unit of output is higher. This is what is currently happening in Australia. Unit labor costs in the year to March 2023 went up 7.9 per cent.

But again, that’s just not wages – it’s also the business investment, technology, process side of unit labour costs.

Productivity affecting inflation.

There are a few different ways we can see inflation coming down. One is productivity growth which eases unit labour costs by allowing each dollar of labour to be more productive, create more output.

During COVID lockdowns and through 2020 and 2021, we observed strong measured productivity growth. But this growth was unsustainable and had to reverse.

The unwinding COVID productivity growth should flow through. However, it is important to remember the ten years before COVID-19 saw very little productivity growth. It was only around 1.1 per cent on average every year. The five years to 2019 had an annual average of just 0.5 per cent annual productivity growth.

We need to see better productivity growth to get inflation back in the balance. This is because it's not that wage growth is going up too quickly, it's that wage growth is not being offset sufficiently by increases in productivity.

We can get a pay rise above inflation if productivity is growing. But it's hard for wages to go above inflation when productivity is not allowing us to actually get more out of each hour of work.

We also know that because of the very low unemployment rate we're seeing now, there are limited gains in productivity unless the labour market softens.

Wages going up

Wage growth grew 3.7 per cent year on year but unit labour costs grew 7.9 per cent and that's because each hour of labour was producing less for the year and was  more expensive.

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We can't do as much about productivity growth as we can do about demand. The less people want to buy, the harder businesses have to work for their money. Which makes businesses more likely to absorb the extra costs of doing business rather than pass those extra costs onto the consumer.

Because many households in the country still have savings, businesses have been comfortable in passing on costs to consumers rather than absorbing those rising costs of doing business and creating lower profit margins.

Current trends in the labour market, including low unemployment and continued elevated job ads, means wage growth won't be slowing down any time soon. So that ‘solution’ to inflation is likely to be far away.

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We think the Reserve Bank is likely to raise the cash rate to 4.6 per cent, hiking it in both July and August. And once the cash rate hits 4.6 per cent, we think it will stay that way until late 2024.

If households were at a widespread risk of having financial stability issues, the Reserve Bank may need to cut earlier. However, mortgage arrear rates are very low. Many people with home loans also have excess savings buffers and this reduces the average household risk of coming into financial stress.

In saying that, of course, there's a wide range of financial situations among households. In truth, economic pain will not be felt evenly across households.

There are some households already struggling - but there are more households in the Australian economy able to muddle through, meaning the Reserve Bank will not have a strong enough reason to cut rates for the purpose of financial stability.

We also have to remember inflation hurts every single person whereas higher interest rates only temporarily create economic pain for some.

Adelaide Timbrell is Senior Economist at ANZ.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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