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The Laptop Warrior, the Barista and the Governor

For domestic inflation pressures to ease, productivity growth needs to recover to pre-pandemic norms. A recovery looks set to occur because the causes of productivity’s decline are ripple effects of the pandemic, and are now unwinding.

As the supply disruptions stemming from pandemic and war start to unwind, and goods inflation eases, attention naturally turns to the domestic sources of inflation, especially for services. Central to the questions of how much domestic factors have driven inflation, and how quickly these might ease, is the pace of growth in labour costs. 

Unit labour costs – the amount of labour compensation required to produce a unit of GDP – is imperfectly measured and volatile, being the ratio of two other imperfectly measured things. A simple rule of thumb to approximate its growth rate, though, is to subtract productivity growth (which to an economist is simply growth in GDP per hour worked) from the growth rate of average earnings per hour. (The correct calculation is more complicated, but this simple approach is usually close enough.)

Average earnings per hour can also be volatile, affected by compositional changes in the workforce, patterns of overtime work and other payments. To assess whether a particular rate of wages growth is consistent with inflation stabilising at the desired rate, one can also look at the same rule of thumb with other measures of labour cost growth. The Wage Price Index (WPI), for example, strips out compositional shifts. It is therefore often considered a better guide to trends in growth in labour costs, even though it does not capture all labour costs. 

Westpac Economics’ current forecasts (PDF 426KB) see the WPI remaining at its current peak year-ended growth rate of 4.2% for the first half of the year, before turning down and reaching the low 3s by the end of the year. A key reason for the decline is that the outsized increase in September quarter 2023 drops out of the calculation. We do not expect the Fair Work Commission to hand down an increase in award and minimum wages of anywhere near the scale of last year’s increase. Inflation has declined significantly over the past year, so the increase needed to compensate for inflation is likewise smaller this round. Individual wage agreements are also already seeing some slowdown in wage rate increases.

Wages growth with a 3 in front of the decimal point is consistent with inflation stabilising around the midpoint of the RBA’s 2–3% target range, provided trend growth in productivity is in the same broad range as it was in the years leading up to the pandemic.

Productivity had instead outright fallen in 2022–23, leading to concerns that it might not return to pre-pandemic trends, and a renewal of the perennial calls for policy reforms, to reverse the decline.

These concerns are, in our view, misplaced.

The Westpac Economics house view has for some time been that the necessary upturn in productivity growth is emerging and can reasonably be expected to continue. This view stems from our analysis of why productivity fell in 2022 and 2023. Without an explanation for that decline, you cannot have any confidence in the turnaround. 

As Westpac Economics colleague Pat Bustamante explained in a recent note, there are indeed ready explanations for the recent decline in productivity. The ripple effects of the COVID-era compositional shifts in employment, the concentration of recent immigration in students working in jobs that account for less output per hour and the surge in population itself are all factors. Importantly, they are all factors that will inherently unwind, and no longer drag on measured productivity. This supports a view that productivity growth will indeed recover, and that wages growth in the 3s will still be compatible with inflation at target.

To really understand what went on, it helps to build a toy economy in your head.

Imagine a world where there are only two sorts of jobs: the kinds of jobs you do using a laptop, and baristas. And imagine that – like in the more complex real world – the laptop jobs happen to produce more GDP per hour than the barista-type jobs. (It would be a misnomer to say the laptop workers are ‘more productive’ than the baristas. They are just doing different work.)

Now imagine that this toy economy goes through a lockdown. Everyone goes home; the laptop workers open their laptops and continue working, while the baristas are at home, not working and collecting JobKeeper. GDP and total hours worked both fall but hours worked falls by more. Measured productivity therefore increases.

Then, when the economy opens up again, the baristas can start working again. GDP and total hours worked both increase, but hours worked increases by more and measured productivity falls. 

The real world is more complex, but this simplified model gets to the essence of what happened. The compositional shifts in who was working when go a long way to explain the gyrations in labour productivity seen in the past few years.

There are two more wrinkles to this story that also help explain developments. First, when the economy opens up, so do its borders to the other toy economies. The toy economy we are considering receives a rush of migrants who happen to mostly be students. Those students will have laptop jobs one day, but in the initial phase of their residence, they work as baristas. This change in composition of the workforce drags down average productivity further.

Second, all those students working as baristas didn’t bring coffee machines with them. So the workforce overall has less capital per worker, something economists call ‘capital shallowing’. The capital stock simply could not keep up with the expansion in the labour force. This also dragged on measured productivity. 

If you are the Governor of the central bank of this toy economy (a laptop job, of course), you would be aware of these shifts, and of the likely unwind in population growth after the initial surge. Your investment forecasts would lead you to a view about whether the ratio of capital to labour would recover and support a recovery in productivity. This would in turn affect your view about the inflation outlook.

In the more complicated real economy you might also point to some additional factors, as the real-life RBA did in its February Statement on Monetary Policy. They include supply disruptions in construction (even though measured gross value added per hour worked in that industry has not been a particular laggard recently), and training periods needed after changing jobs (even though job mobility has largely returned to pre-pandemic rates). These additional factors are the gravy, though; the real meat of the explanation is that, as the RBA put it, ‘much of the weakness in productivity has been a by-product of the pandemic’.

A separate issue is that global productivity trends were also weak in the years leading up to the pandemic. There are a number of possible explanations for this, with the economics profession yet to settle on a consensus view. The important point is that there are good reasons to expect productivity to continue turning around from its recent decline, as it has already started to do, and no good reasons to expect it to continue to fall. Given this, the base case for the economic outlook should be that domestic inflation pressures ease in the period ahead.

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