Stagflation threat receding rapidly, bringing rate cuts into frame

By Pat Bustamante Senior Economist, Westpac

Labour productivity continues to improve as the supply side of the economy normalises. As a result, growth in unit labour costs is now running at pre pandemic rates, and we expect these costs to moderate further, consistent with our call that the RBA will ease rates by the end of this year.

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A critical outcome largely missed in the March quarter National Accounts was the significant stepdown in unit labour cost growth – a measure of the domestic cost base and a key driver of underlying inflation. This measure of labour costs is now growing in line with pre pandemic rates, when inflation was persistently below the RBA’s 2-3% target.

Importantly, we do not expect growth in unit labour costs to accelerate from here. Instead, the significant stepdown is expected to be sustained going forward. The benign Fair Work Commission (FWC) 2024-25 minimum and award wage increase means we are unlikely to see the “spike” in labour costs in the September quarter, which has characterised the data over the past two years. In fact, we expect to see labour costs moderate further given the softening in labour market conditions and the turnaround in labour productivity experienced since the middle of 2023.

It is no surprise that this was missed. The focus has been on the demand side of the economy and whether policy settings are restrictive enough to bring demand and supply into better balance. However, as we have been saying for some time, the supply side of the economy is not static or fixed. The supply side continues to respond to the ripple effects of the pandemic.

We have had a transitory supply shock coming out of the pandemic, with sharply lower population growth and falling productivity now giving way to resurgence in population growth and a turnaround in productivity. This is increasing supply through higher growth in productivity. At the same time, this positive shock is also reducing labour costs.

Moderating unit labour costs is inconsistent with elevated or accelerating inflation. While new supply shocks (shipping difficulties and supply chain breakdown) present a fresh risk, at this point the data is consistent with positive supply side shocks dominating, leaving the risk of stagflation in Australia very low.

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Stagflation threat receding rapidly, bringing rate cuts into frame

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