Markups and downs
The RBA no longer says that wages growth is too high to be consistent with inflation returning to target. But how did it come to that conclusion in the first place?
Last week we noted that, in its September post-meeting communications, the RBA was no longer saying that wages growth was ‘above the level that can be sustained given trend productivity growth’, as it did in August. How did it make that judgement in the first place, and why does trend productivity growth come into the story?
The answer rests on the RBA’s beliefs about how the economy works, based on analytical frameworks first introduced in the 1990s. This framework starts from the premise that consumer prices can be represented as a markup over labour and other costs. For a given percentage markup, the growth rate of prices (inflation) will line up with the growth rate of costs.
If the split between labour and non-labour costs is also stable, then growth in labour costs will also line up with inflation. Labour costs per unit of output is equivalent to labour costs per hour divided by output per hour. Ignoring some second-order maths pedantry, this means that inflation should line up with growth in labour costs per hour (average earnings growth) minus growth in output per hour worked. Output per hour worked is the definition of productivity in the national accounts, and what economists mean when they say ‘productivity’. The link between productivity and achieving the inflation target comes from this relationship.
To make the example concrete, if you think productivity growth is about 1% per year, and wages growth has a 3 in front of the decimal point, then according to the RBA’s rule of thumb, you should be relaxed about wages growth being consistent with the inflation target: 3-and-a-bit minus 1 is 2-and-a-bit, and so would be in line with inflation in the 2–3% target range.
If you have been following along, though, you will notice that there were a lot of things held constant in this mapping between wages growth, productivity growth and inflation. Firstly, it requires that growth in labour costs and in non-labour costs are similar and persistent. Secondly, it assumes that the percentage markup over costs is constant. Neither is true in the short run or even the medium run.
Non-labour costs have been a key driver of the recent surge in costs. Transport and energy costs, building materials and insurance had all been rising faster than overall CPI inflation until recently; insurance inflation is still at double-digit rates, being downstream of some of the other costs. Labour costs have also been growing quickly, but since 2021 growth in the Wage Price Index (WPI) lagged inflation in final-stage producer prices.
In addition, a period of strong growth in unit labour costs will not persist if productivity growth increases but is not matched by a pick-up in wages growth. The RBA recognised this in its August media statement by expressing the relationship as being between wages growth and trend productivity growth. The trend is not quite the right measure to use in a markup model, but this framing points to where future productivity growth might converge. However, the Statement on Monetary Policy still focused on recent outcomes. One of the reasons cited for the RBA’s assessment that supply capacity was weaker than previously thought was ‘wages growth has been high relative to productivity outturns’.
Meanwhile, markups and profit margins do not stand still. Mechanically mapping the latest data on unit labour cost growth to the latest inflation outcome would be misleading as a forecast. Even the RBA’s markup model for forecasting inflation allows the markup to vary over the cycle.
It is understandable that the RBA would not want to get into the weeds on whether profit margins might rise or fall. It matters whether you are talking about markups over average cost (as implied by the RBA’s markup model) or over marginal cost (the focus of much of the academic literature). And the literature has not even reached a consensus on whether markups rise or fall when demand is strong. Any discussion of the issue would get messy. The controversy around whether ‘greedflation’ had been a factor in Australia’s inflation experience also makes a nuanced discussion difficult. That said, implicitly assuming that margins are constant and unit labour costs map mechanically to inflation is not ideal, either.
Finally, all this assumes that productivity growth in the whole economy is the relevant measure for this model of inflation determination. Yet there are significant sections of the economy where the price as measured in the CPI and the costs implied by wages and productivity are not tightly linked. Public sector and other non-market activity simply is not priced this way, at least not in the short to medium run.
This is the point our Westpac Economics colleague, Senior Economist Pat Bustamante, made in his recent note. Partly because the share of activity in the (low measured average productivity) non-market sector is rising, measured total productivity growth is weaker than usual. In the market sector, though – the part of the economy where markups matter for pricing – productivity growth is already above 1%.
Why has the monetary policy discourse in Australia become so hung up on productivity growth? On top of the RBA’s use of markup models, it is a peculiarity of the Australian economic discourse more generally to worry about productivity growth and assume that the government should do something about it. We have a Productivity Commission, after all – it must be a government responsibility, right? This mentality is reinforced by a narrowly country-specific view (outside the RBA, to be fair) that does not recognise that the slowdown in trend productivity growth since the GFC was common to most Western economies.
Another factor is an apparent view that wages growth will be too sticky. Our own forecasts see the WPI measure of wages growth slowing from 4.1% over the year to the June quarter to 3.5%yr September and 3.2% over calendar 2024, as the outsized September quarter 2023 increase drops out of the calculation. The RBA’s forecasts are noticeably higher – 3.6% over 2024 – and the average earnings measure more relevant to the unit labour cost calculation is higher still. And maybe they will be right, but this is still a significant slowing.
Even using their own forecasts, though, there was a choice between ‘wages are above the level that can be sustained’ and ‘the expected decline in wages growth would return it to levels consistent with’. The shift in language in the September media release better aligns with a forward-looking view. When the WPI and national accounts data for the September quarter are released ahead of the RBA Board’s December meeting, a further pivot in RBA rhetoric might be needed. If we are right that the Board will wait until the February 2025 meeting to cut rates, then perhaps the December meeting before it will be the point to acknowledge that Australia’s domestic cost story has not been that unusual after all.
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