Pendal: Farewell inflation, hello unemployment
Employment will be an important economic signpost for monetary policy in Australia. Here's where it's headed, according to Pendal's Timothy Hext
Excerpt from Pendal's quarterly update on the themes driving Australian fixed income markets
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GLOBALLY, the battle against high inflation is over.
While the Reserve Bank of Australia feels it’s still in that fight, the rest of the world has moved on, focusing instead on unemployment.
US Fed chairman Jerome Powell reframed the discussion at last month’s Jackson Hole economic symposium.
“The balance of risks to our two mandates has changed… Inflation is now much closer to our objective, with prices having risen 2.5% over the past 12 months. After a pause earlier this year, progress toward our 2% objective has resumed. My confidence has grown that inflation is on a sustainable path back to 2%,” he said.
“Today, the labour market has cooled considerably from its formerly overheated state… The increase [in unemployment] mainly reflects a substantial increase in the supply of workers… It seems unlikely that the labour market will be a source of elevated inflationary pressures anytime soon. We do not seek or welcome further cooling in labour-market conditions.
“The upside risks to inflation have diminished. And the downside risks to employment have increased.
“The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
The bolding was our emphasis, but Powell’s comments were crystal clear: rates are going down, either slowly or quickly, but they are going down.
This then begs the question of what to think in Australia.
The RBA is far from convinced that our inflation is heading back to target any time soon. Its official forecasts have headline CPI hitting 3% by year-end, helped in large part by government subsidies. However, the RBA’s preferred trimmed mean inflation, its version of core inflation, is not forecast to hit 3% till the end of 2025.
Australia was behind the pack on the way up in inflation, and then cash rates, and is now in a similar position on the way down. The RBA probably knows this, but believes it serves it well to keep jawboning rate expectations while the catch up is underway.
If the main event in the US is switching from inflation numbers to unemployment rates, you can expect a similar dynamic to appear here over the next six months.
The Fed has effectively revealed that its full employment rate is around 4.25%.
So, this quarter, we will dig deeper into Australia’s employment market – focusing on where the unemployment rate is going and where the RBA believes full employment is.
Australian employment: a narrow jobs boom
The latest quarterly employment report, breaking down employment by industry, paints a very interesting picture.
The three years from May 2021 to May 2024, a period characterised by the RBA as strong labour markets, shows a very uneven job market. Australia has added 1.33 million jobs, or an increase of 10.2%.
However, healthcare and social assistance, which only made up 14% of the job market in 2021, added 453,000 jobs. Construction, which was 9% of the job market, added 209,000 jobs. That’s two sectors that accounted for less than a quarter of the job market in 2021 adding half the jobs.
By contrast, retail employment – which was 10% of jobs – has added no jobs in three years. Mining and manufacturing have also largely flatlined.
The initial boom in construction jobs was boosted by the HomeBuilder subsidies during Covid. However, those subsidies have now passed, and it is largely state government infrastructure projects driving strong job growth.
In healthcare and social assistance, the gains had been partly Covid-led but this has continued beyond the end of the pandemic. This is largely around the massive boom in the National Disability Insurance Scheme (NDIS).
As well as new job creation, this has seen some jobs reclassified as social assistance, as workers chase the higher wages on offer from the scheme.
What are other metrics saying about employment?
While the unemployment rate is a key metric when following the job market, there are other metrics which give an earlier sign of excess supply or demand in the jobs market.
Firms initially respond to demand conditions by offering existing workers more or less hours. This increased during 2021 and 2023, but hours worked per employee are now back at pre-Covid levels. Firms have been hoarding labour, offering fewer hours in response to reduced demand rather than reducing employees.
Over the past year, employment is up more than 3% but hours worked only 0.9%.
Another similar metric is the under-utilisation rate. This not only includes unemployment but also part-time workers wanting more hours.
Generally, around 25% of part-time workers are considered under-utilised (survey based), so any shift from full time to part time will lift the under-utilisation rate. This has a better correlation to wages than the unemployment rate, as shown in a graph from Minack Advisors below.
Based off this, we should expect wage growth to slow further.
The RBA looks at a wide range of employment indicators beyond just unemployment. In its recent Statement on Monetary Policy (SOMP), the central bank published a very useful employment dashboard.
It was largely trying to make the point that while conditions have eased, they remain tight by historical standards. This has led the RBA to talk about the “ongoing strength in the labour market” contributing to its view that the “gap between aggregate demand and supply in the economy is larger than previously thought.”
The same case could be made for the US, but as we saw above, the Federal Reserve has concluded that current employment levels are desirable and non-inflationary.
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So where exactly is full employment in Australia?
The RBA has full employment in its mandate. It defines it as the maximum level of employment consistent with low and stable inflation. Unlike price stability, the RBA has never attempted to define a specific level. The level is seen as fluid and as the saying goes “we’ll know it when we see it”. This has led to a rather strange concept of a non-accelerating inflation rate of unemployment (NAIRU), which it believes changes over time.
The trouble with NAIRU is it’s rather circular and unambitious.
If inflation is at target then, by definition, whatever the unemployment rate is must be full employment. It is inferred. This led to unnecessarily tight fiscal and monetary policy during the period 2010-20, whereby (courtesy of NAIRU) part of the 700,000 or so unemployed were seen as a necessary buffer to stop workers pushing wage demands too high.
Conventional wisdom through this period, led by the RBA and largely unquestionably followed by the economics community, was that NAIRU was somewhere around 5-6%. It was even worse in the 1990s when RBA models suggested NAIRU was near 7%.
A very strange idea to have such a large group of people not working, with all the associated impacts, for the supposed benefit of the community.
Fast forward to 2024 and the RBA now identifies 4.5% as a target for NAIRU, as evidenced by its 2025 forecasts of CPI and unemployment.
Therefore, policy will remain tight until more workers are unemployed.
In September 2023, the government produced a whitepaper on full employment which further entrenched this idea: Working Future: The Australian Government’s White Paper on Jobs and Opportunities.
It graphed the concept of NAIRU:
This suggests there is some sort of natural rate of unemployment that we cyclically move around. Only micro reforms like training and job flexibility can reduce it by reducing structural under-utilisation, bringing those excluded from the workforce back in. It ignores the potential role that the government can pay in creating jobs demand.
Frictional unemployment is always there as people move between jobs and, in fact, will often increase in stronger job markets as more workers leave their jobs for better opportunities. The RBA estimates this around 1.5%.
There are also structural reasons people may be out of work, as certain industries or skills become redundant or jobs move between areas. The RBA estimates this number to also be around 1.5% through time.
So perhaps 3% is true full employment.
Japan has successfully run its unemployment there without inflation, though the country has a number of other significant factors at play. However, the RBA clearly feels it is significantly higher than 3%, currently targeting 4.5%.
We are likely already at or below full employment
Unfortunately, we don’t get unemployment by job category but if you did, you would likely find there is excess capacity in many industries.
As mentioned previously in this paper, it is rare to see strength in the job market so concentrated in two areas – construction, and healthcare and social assistance.
They have both had demand shocks applied to them over the past five years and, therefore, have been through full employment but – leaving the other 17 sectors of the economy behind – less than full employment.
There will be some workers who can transition into construction and healthcare and social assistance, smoothing the moves, but the RBA is forced to use macroeconomics to deal with what is more a microeconomic issue.
In an ideal world, the government would get the NDIS under control and state governments would pull back on all but the most essential infrastructure, allowing the RBA to then cut rates back to levels nearer to its inflation target.
This will not happen anytime soon, though the rate of growth in the NDIS is slowing from high levels. Only NSW is showing any pullback on infrastructure spending. Even if this were to spread, the need to construct new homes should more than soak up any excess supply in construction.
Overall wage growth is coming down simply because inflation is coming down. Workers overall are happy to receive wage rises, which are now higher than inflation. The cost-of-living crisis is no longer a crisis, though as always some are still doing it tough.
Conclusion
The narrow path that the RBA speaks of is already in place.
Our view is that 4.2% unemployment is sufficient to not stop the move of inflation sustainably back into the target band. Unemployment could stay here, and we would still see inflation back below 3% and cash rates back to 3.5%.
If unemployment were to push up to 4.5% or higher, the economy would be sluggish enough to allow for rates to move back towards 3% or lower.
Either way, despite decent movements lower in bond yields over the past few months, we expect three-year bonds to push towards 3% and 10-year bonds to 3.5% over the period ahead.
About Tim Hext and Pendal’s Income & Fixed Interest boutique
Timothy Hext is a portfolio manager and the head of government bond strategies in Pendal's Income & Fixed Interest team.
Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.
Pendal's Income & Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
This article has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances.
The views expressed in this article are the opinions of the author as at the time of writing and do not constitute a recommendation to buy, sell, or hold any security. Any views expressed are subject to change at any time.?To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.
Partner, Financial Services
5 个月Good article