Australia has had problems with inflation every time the unemployment rate has been below 5%. In the prior boom, CPI went to 5% with the unemployment rate at 4%, despite the most capital friendly IR arrangements (and Government) in Australia’s history. In the Q2 SOMP the RBA forecast an unemployment rate of 4.25% but CPI of ‘only’ 3.25%. Below, I argue that given the changed institutional structure of the economy, and the political backdrop, inflation may rise more substantially than the RBA expects.
My read of the RBA’s Q2 SOMP is that the RBA intends to take policy from the present mildly restrictive setting to an outright restrictive setting over the next few months. They are doing this to prevent the unemployment rate from falling too far and thereby setting off an inflationary wage-price spiral.
You get wage price spirals as follows. A lower unemployment rate increases worker bargaining power, and improved bargaining power allows labour to attempt to increase their share of national income – by putting up their price (wages).
But isn’t inflation a monetary phenomenon? Yes it is – think of the RBA’s policy as restricting the money supply so that at the new higher price level, we run out of cash before we are done buying as much capital and labour (GDP) as we were previously able to purchase. Thus, if some workers put their price up, either capital or other workers have to put their own price down.
The RBA forecasts the unemployment rate falling to 4.25% by Dec’13, and assuming market pricing for the cash rate (+25bps in Q1’12 and +25bps in Q2’13), thinks that this will push inflation up to 3% by Q4’11 and 3.25% by Q4’13.
So what to do? Raise rates, obviously!
I think the RBA will probably raise their target overnight rate by 25bps in July, and again later in the year (probably November) — with an additional move in August if Q2 CPI is high. The risk is that they end up doing a lot more than this over the next two years, as we are already at full employment, and the mining investment boom is only just getting going.
We start this boom in exactly the wrong place – we already have full employment, we have a new industrial relations system that increases worker bargaining power, a union movement that’s becoming more militant, and a union friendly federal government.
The government’s weakness, and declining popularity, threaten to spark this inflation tinder. There are already worrying signs. The government submission to the Orwellian ‘Fair Work Australia’ supports the union movement’s argument for cost of living adjustments – basically locking in recently high headline price inflation. The union movement are desperate for a win, and the minimum wage submission suggests this government doesn’t have the guts to stand up to them.
Additionally, the unions can read the polls just like the rest of us – it seems unlikely that the federal government will be returned at the next election (slated for 2013, but they may not last that long!), so that means that unions will probably be battling an inhospitable government in a few years time.
Given this, it seems prudent to chalk up a few big wins while the going is good, and build up some credibility – which they may need later on. This means going for the big pay rises right now. My guess is that there will be a big increase in industrial action over the next two years.
The Australian Workers Union’s Paul Howes reminds me a lot of Bob Hawke – and that should worry the RBA. Hawke helped the ACTU make a meal of the smaller 1970s terms of trade boom – blowing up the boom via inflationary wage claims in the 1970s, and thereby hurting the weak Whitlam Labor Government.
Howes, for his part, recently “declared war” on Rio Tinto – and accused Rio CEO Tom Albanese of “sucking the blood of blue-collar workers”. This is a man with his eye on politics, and he seems ruthless. I don’t think he would mind wrecking the current mob’s chances via inflationary wage rises – and hence much higher interest rates – if he got a Hawke-like profile out of it. Read more about Howes here: http://www.theaustralian.com.au/national-affairs/faceless-man-back-on-front-line/story-fn59niix-1226051433314
All of this suggests to me that the structural and political setup of the economy has become much more inflationary over the past few years. If any country is going to have an inflation breakout, it is Australia over the next few years. The RBA’s job is to squeeze the economy tightly enough so that this cannot happen. That is going to require restrictive rates – possibly very restrictive rates.
These hikes are going to be intensely political. I expect that we will hear a lot from the various industries and sectors about how the RBA has gone too far, and how it is really only the mining sector that is doing well — that all the other parts of the economy are doing poorly.
The RBA almost certainly will not say it, but at this point monetary policy is about creating losers. That is the aim of restrictive policy.
We already have full employment — at this point the RBA’s policy is designed to shut down little bits of the economy, so as to make room for the biggest mining boom in 150yrs. The bigger the boom, the more unemployment the RBA has to generate to keep bargaining power at the right level such that inflation sticks around 2.5% per annum.
The stronger the unions, the higher that unemployment rate is. I think that a 4.25% unemployment rate will lead to inflation that is more like 4% – because i think the structural changes and political backdrop mean that we are more likely to see inflationary wage claims at any given unemployment rate.