By MILLIE MUROI, Economics Writer
When the Reserve Bank meets next week, it will probably cut interest rates. But it will be some time before it is comfortable enough to lower them to a level that isn’t grinding down economic growth.
Already, some economists have slammed the bank for being slow to cut rates, saying it’s causing more cost-of-living pain than necessary for people with home loans.
Now that the bank’s preferred measure of inflation is within its 2 per cent to 3 per cent target range and the economy has slowed to a crawl (with the risk of a further slowdown as US President Donald Trump’s tariffs hit home), those criticisms are growing louder.
So, why is the Reserve Bank still determined to keep the economy growing below its potential? A lot of it comes down to the bank’s phobia of pay rises – which, like many modern-day fears, served us well in the past but aren’t so useful today.
One of the first rules we learn in economics is that the prices we pay are determined by the balance between supply and demand: when supply of a good or service outstrips demand for it, prices fall, and when demand exceeds supply, prices rise.
Then, we learn all the reasons why this rule isn’t that simple. For example, if a business has a lot of power (maybe it has few competitors), it can charge more for its goods and services.
On the other hand, when customers hold more power, they can drive prices down. How do you think the Australian government manages to negotiate cheaper prices for medicines it buys from other countries? By acting as a single buyer, representing millions of Australians, which gives it a lot more bargaining power than if you or me, individually, tried to negotiate with the pharmaceutical giants. This is what’s called a “monopsony”.
Put simply: prices are determined by the balance of supply and demand – but also the power balance between buyers and sellers.
Our wages are determined in a similar way, which is what the Reserve Bank has been worried about. At almost every interest rate decision in the past couple of years, the bank has mentioned the strong labour market as a reason for its reluctance to cut rates.
Think of your wage as the price of the work you supply. Workers sell their labour to companies which buy – or employ labour. This is called the labour market.
When there’s more demand for workers than there is supply, we have a labour shortage and unemployment tends to be low. This is the position we’ve been in for the past few years, when unemployment dropped to a record low of 3.4 per cent and has remained historically low at roughly 4 per cent.
While this might seem like a good thing, the Reserve Bank is worried.
Its biggest concern is inflation, which it’s worried could follow the same path it did in the 1970s. That is, prices could spike back up if unemployment stays low and businesses give us big wage rises which, in turn, could feed into higher prices.
How do we know the bank is biting its nails? Because of how carefully it’s treading. While inflation hit nearly 8 per cent in 2022, that figure has fallen a lot over the past two years. Yet in that time, the central bank has cut interest rates only once (and raised them six times).
To be fair, employment is growing robustly (a huge 89,000 additional Australians were employed in April compared with March) and job vacancy data shows there’s still a big worker shortage.
But a “wage explosion” is unlikely given the labour market has changed radically since the 1970s.
Wages have finally started growing faster than inflation, but it’s been at a relatively modest pace of 3.4 per cent over the year – and following a year-and-a-half in which wage growth fell short of price rises.
So, what explains the Reserve Bank’s worries of excessive wage growth?
For one thing, the bank relies on a relatively neoclassical view of how the economy works, one in which demand and supply (in this case, of labour) determine price levels, including wages, with individual firms having little control over how much to pay their workers. It’s why the bank is constantly surprised by the strength of the labour market – and waiting (with little avail) for wages to spring up out of it like a jack in a box.
Meanwhile, this lack of a wage explosion comes as no surprise to a lot of labour economists, including Professor Emeritus David Peetz from the Carmichael Centre.
That’s because the neoclassical view of economics tends to assume everyone has roughly equal bargaining power, while many labour economists acknowledge that isn’t the case – especially in recent years.
Peetz argues that real wages – that is, wages adjusted for inflation – have been held back in Australia in recent decades because workers’ power to negotiate has been persistently eaten away.
“Workers have lost a lot of power since the last wages explosion in the 1970s,” he says, noting that from 2014 to 2022, government policies such as WorkChoices have taken away workers’ bargaining power.
The Reserve Bank isn’t totally blind to this. Their economists have written about bargaining power and its relationship with wages. But their justification of interest rate decisions suggests they don’t give much weight to it.
While the bank might worry the current skills shortage could lead to a wage spike and further inflation as in the 1970s, Peetz points out employers now rarely feel compelled to hand out pay rises in response to skills shortages.
In 2023, Jobs and Skills Australia, a federal government agency, asked employers what they do in response to a skills shortage. Only 1 per cent said they would adjust how much they paid their workers.
Why? Because there’s not as much pressure to do so when only one in seven Australian workers are part of a union (it was one in two during the 1970s). The threat of industrial action such as strikes is much smaller. Only 100,000 working days were lost in 2021 compared with 6.3 million working days lost to industrial action in 1974.
While workers in 1974-75 managed to win wage rises of 10 per cent accounting for inflation, workers went backwards by 3 per cent in 2021-22.
This is because of several changes including legal changes in recent decades which have made collective bargaining (in which workers across an entire industry band together to negotiate) less common than enterprise bargaining, in which workers negotiate directly with their employer.
Wage increases won through enterprise bargaining apply only to workers at a specific business or site, limiting those workers’ negotiating power as well as how far the wage rise, if won, can spread. While a wage rise at one company might put some pressure on another company to do the same, in practice, this kind of flow-on impact is limited.
While changes under the Albanese Labor government such as its same job, same pay policy have started to hand more power back to workers, rampant wage rises – and a resurgence in inflation – are far from a big threat to the economy. The Reserve Bank can, and probably should, relax a bit, too.
