Although aggregate demand in the Australian economy is currently a little subdued the Reserve Bank of Australia seem to have plenty of ammunition available for stimulatory purposes. With the cash rate being 4.75% (see graph below) it could be said that the RBA are ahead of the play with regard to rate increases. The labour market appears to be strong and the terrible events in Japan will no doubt lead to a surge of commodity demand as rebulding and reconstruction proceeds. With this in mind there is the chance of capacity constraints and therefore investment in the mining and related industries will be essential. In the year the RBA will need to be aware of demand pressures as the economy puts its foot on the gas once again. With this expected growth and boost to employment figures the RBA will weary of the Australian NAIRU (see previous post – Australia’s NAIRU) and will want this unemployment figure to drop at a very slowly rate as inflationary issues could become prevalent. The Treasury estimate for the NAIRU (also know as the Full Employment range) is between 4.5% and 5% – see graph below.
So, while Wall Street became fixated by sub-prime mortgages and collateralised debt obligations, Australia concentrated on its natural endowments. Remember Australia never went through an official recession during the finanacial crisis.
Reserve Bank of Australia – Cash Rate
Unemployment and the NAIRU
The pick-up in unemployment, which was above RBNZ expectations, should indicate that Alan Bollard will wait for a more robust rebound in the economy before tightening monetary policy. The indications are that he will wait till September before implementing contractionary measures. Commentators are optimistic in the long-run as, eventhough the unemployment figures are disappointing, some surveys are promising:
– business and consumer surveys are solid from 2010
– expectations about hiring in the labour market are positive
What is worrying is that wage and salary inflation is on the up, with unit labour costs running near 2% per annum, and nominal rates pushing 4%. Even with this level of unemployment one wonders what is the NAIRU – the non-acclerating inflation rate of unemployment. During the upturn economists looked at 5% being the rate at which unemployment didn’t impact on prices. These figures also suggests that we have some structural unemploymnet issues and a mismatch between vacant jobs and the skills of the unemployed.
NAIRU – non-accelerating inflation rate of unemployment – is part of the CIE A2 course and below is a look at how it might affect the Australian economy and explanation of the theory.
While the US economy appears to be in danger of slipping into a double-dip recession and sovereign debt risks casts a shadow over Europe, the Australian economy powers on. The reason for this is the country’s biggest resources boom in more than a century. Perhaps the challenge of managing Australia’s economic success will turn out to be more difficult than steering the economy through the financial crisis. If economic growth picks up to 4% in the coming years, which is above the annual average rate, this will lead to serious capacity constraints and the economy would be heading towards full employment. With unemployment very close to 5% which Treasury estimates is Australia’s NAIRU – non-accelerating inflation rate of unemployment – a measure used to gauge when labour shortages start to feed into wage and inflation pressures. This would then threaten the RBA’s target band for inflation (2-3%) and lead to higher interest rates which would hurt those sectors of the economy that haven’t been a part of the commodity boom from China.
Explaining the NAIRU
Bill Phillips (of Phillips Curve fame) discovered a stable relationship between the rate of inflation (of wages, to be precise) and unemployment in Britain from the 1850’s to 1960’s. Higher inflation, it seemed, went with lower unemployment. To economists and policymakers this presented a tempting trade-off: lower unemployment could be bought at the price of a bit more inflation. However, Milton Friedman and Edmund Phelps (who both later picked up Nobel prizes, partly for this work), pointed out that the trade-off was only temporary. In his version, Friedman coined the idea of the “natural” rate of unemployment – the rate that the economy would come up with if left to itself. Now economists are likelier to refer to the NAIRU (non-accelerating inflation rate of unemployment), the rate at which inflation remains constant. The theory is explained below:
Suppose that at first unemployment is at the NAIRU, u* in the graph below, and inflation is at p0. Policymakers want to reduce unemployment, so they loosen monetary policy: that stimulates spending, so that unemployment goes down, to u1. Inflation rises to p1, along the initial short-run Phillips curve, PC1. But that raises inflationary expectations, so that workers demand higher wage increases and real wages rise again. Firms shed labour, returning unemployment to u*, but with a higher inflation rate, p1. The new short-run trade-off is worse, with higher inflation for any level of unemployment (PC2). In the long run the Phillips curve is vertical (LRPC).