The Outlook for Inflation and Employment

Speech

Notes

The Outlook for Inflation and Employment Marion Kohler [ * ] Head of Economic Analysis Department Address to the ABE Annual Forecasting Conference Sydney – 13 February 2024 Audio 26.1MB Q&A Transcript Download 574KB Good morning. It’s a pleasure to be back at the ABE’s Annual Forecasting Conference. The year
just past has certainly been another eventful year for forecasters. Today I wanted to speak to you about three topics. I’ll begin with the RBA’s outlook for the
Australian economy. We’ve just updated it in last week’s Statement on Monetary
Policy . I’ll then discuss our current assessment of spare capacity in the labour market
and in the economy. And I’ll round this out by talking about some of the changes we’ve been
making at the RBA to enhance transparency. This includes changes to the Statement on Monetary
Policy , which we’ve published last week for the first time immediately after the Board
meeting. The Statement has also had a makeover, designed to give you new insights into how
we are seeing the key economic issues. The outlook for the Australian economy I’ll start with our views on the outlook. A year ago, when I last spoke to you, we’d just seen
the highest rate of inflation in several decades (Graph 1). And monetary policy had been tightened
at a brisk pace from the ultra-accommodative level during the pandemic. ¹ Graph 1 Since then, the economy has evolved broadly in line with our expectations – inflation (measured in
underlying terms) and GDP growth are not too far from where we thought they would be a year ago. Similar
to the experience of many advanced economies, two key forces driving developments in the economy continue
to be high inflation and the restrictive monetary policy needed to address it. Inflation is still high but is expected to ease gradually First on inflation. It’s still high and above the RBA’s target range. But it has been coming
down, and at a slightly faster rate than our forecasts three months ago. Headline inflation is
4.1 per cent, around half of its peak a year ago. Underlying inflation – we often use a
trimmed mean to measure this – has also decreased over the same period; it is now sitting at
4.2 per cent. Looking ahead, it will take some time for inflation to get back within the target range. Based on our
central forecast, we expect it to return to the target range in 2025, and to the midpoint in 2026
(Graph 2). I’d like to stress that there is substantial uncertainty around forecasts that far
out – you can see that in the blue uncertainty ‘fans’ around the central forecast. Our
forecast reflects our expectation that subdued economic growth will balance demand and supply of goods
and services in the economy and labour market conditions will ease to be around levels consistent with
sustained full employment and inflation at target. I’ll return to our assessment of spare capacity
later. Graph 2 An important trend underneath the aggregate inflation figures is the divergence in the path of core goods
and services price inflation (Graph 3). Like in many other advanced economies, most of the decline
in inflation so far in Australia has been from lower goods price inflation. In fact, a faster decline in
goods inflation was the main driver of the lower-than-expected outcome in the most recent inflation
release. We are seeing the earlier easing in global upstream costs being passed through to the prices
consumers are facing. We have been hearing for some time now from firms in our liaison program that
supply chains have been improving and imported goods inflation easing. Subdued demand growth has also
contributed to the decline in goods inflation. Looking ahead, we expect goods inflation for many
categories to be low for a time. This reflects the earlier improvements in global supply chains and
below-trend global demand. Recent events in the Red Sea highlight that this moderation in global goods
inflation might be bumpy, however. Graph 3 But services price inflation remains high and broadly based. This strength has been because of continued
pressure from the level of demand exceeding supply alongside strong growth in domestic costs. Firms in
our liaison program continue to say that they face pressure from higher labour and non-labour costs like
professional services, logistics and insurance. We are forecasting that services inflation will decline
from here, but only gradually as demand moves into better balance with supply and domestic cost pressures
moderate. This decline in services price inflation is necessary for the inflation target to be achieved
over time. The overall cost of labour is one cost consideration for firms when setting the prices of the goods and
services they provide, particularly in the relatively labour-intensive services sector. We expect wage
growth to be around its peak and to decline gradually in line with the easing labour market
(Graph 4). We’re already seeing signs of easing wage pressures in some industries, particularly
in business services. Graph 4 Importantly though, overall labour costs faced by firms are also determined by labour productivity –
that is, the output produced by each hour an employee works. Recent weak productivity outcomes have been
an important contributor to high labour cost growth. Our forecast for wages growth is consistent with
inflation in the target range, assuming that productivity growth returns to around its long-run average
over the next few years. I’d like to emphasise that productivity growth is a structural factor that
has a lot of measurement noise over a high frequency, so it takes a longer period of observation to get a
decent gauge of it. So, quarterly movements of productivity are not a useful guide when it comes to
assessing the relationship with inflation and average earnings growth over the next few years. While it is difficult to forecast productivity growth, much of the recent weakness in productivity has
likely been a by-product of the pandemic and the economic cycle and so can be expected to unwind over the
next few years. Examples of these temporary factors are the capacity challenges faced by firms related to
pandemic or weather disruptions, capital shallowing (as the increase in hours worked outpaced growth in
the capital stock) and additional employee training required given the high turnover and jobs growth
we’ve seen in a very tight labour market. As these influences fade or indeed unwind, productivity
growth should pick up in the period ahead. Growth in economic activity will be subdued in the near term Turning to economic activity, we’ve seen activity here and in most advanced economies soften over the
second half of last year in response to high inflation and tighter monetary policy. A common component of
this recent softness is weaker consumption growth. In Australia, high inflation, higher tax payments and
higher interest rates have, together, significantly reduced household incomes. And many households have
responded to this by cutting back on their spending or making other adjustments to their finances, like
saving less or in some cases drawing on their savings buffers (Graph 5). Graph 5 Going forward, we expect economic growth to remain subdued in the near term as inflation and earlier
interest rate increases continue to weigh on domestic demand growth, particularly household consumption.
For the next few quarters, the pressure on household budgets from declines in real incomes over the past
couple of years is expected to continue to drag on consumption. We expect it to affect consumption a bit
more than in our forecasts three months ago. This period of below-trend demand growth will bring about a
better balance between supply and demand in the economy. Growth in non-mining business and public investment has been high over the past year. This has been
supported by a large pipeline of public and private sector construction projects and an easing of supply
constraints. While we don’t expect to see a continuation of the high growth rates of
2023, activity in the construction sector is forecast to remain at a high level
(Graph 6). So, there will likely continue to be capacity constraints in the industry, which firms in
our liaison program report particularly for the construction of infrastructure projects. Graph 6 Later this year, GDP growth is forecast to pick up gradually as the effects of high inflation ease
(Graph 7). The impact of earlier increases in the cash rate on GDP growth will also start to fade.
This forecast is underpinned by a pick-up in consumption growth as real household income growth turns
positive again this year. Graph 7 There are uncertainties to the outlook As always, there are a range of uncertainties around these forecasts, and I’ll briefly touch on two
key ones we have been considering. First, while we have a good idea of how tighter monetary policy has
affected household incomes, the full effect on household consumption is still to play out. It is possible
that – following a period of large declines in real incomes – households save more of their
income than we expect and so consumption remains subdued for longer than anticipated. This would put
downward pressure on labour demand and inflation. But there could also be developments in the economy that would mean it takes longer to get inflation back
to target. This could happen if households save less or draw down on their savings to support spending to
a greater degree than assumed in our central forecasts. The pressure on labour or non-labour costs could
also be more than we expect – for instance, from poor productivity outcomes or unexpected supply
shocks. The longer inflation stays away from target, the greater the risk that inflation expectations
drift higher. And history shows that, if inflation expectations were to drift higher, it would require
more monetary policy tightening and a costly period of higher unemployment to stabilise inflation
expectations and return inflation to target. Full employment and spare capacity Let me now turn to developments in spare capacity. We have increased our focus on this area in the Statement , including by publishing our assessment of spare capacity in the labour market and
the economy. We have also published a chapter on full employment in the Statement , which
explains how we assess full employment, expanding on a speech the Governor made late last year. ² For
monetary policy, full employment is the maximum level of employment that is consistent with low and
stable inflation. I’ve previously highlighted the challenges around measuring spare capacity in the labour market and
the economy. ³ Full employment cannot be observed directly or
summarised by a single statistic. Any single labour market indicator provides only a partial view of
spare capacity in the labour market. It also changes over time as the structure of the economy evolves. For this reason, we draw on a broad set of information to form a comprehensive assessment of how close the
labour market is to full employment. This information includes labour market data, survey measures,
model-based estimates and liaison with businesses. We also seek the views of a wide range of
stakeholders. Of course, we also use economic models to infer spare capacity. Each of these models has
their own strengths and weaknesses. So, using a number of approaches allows us to capture a better, more
diverse range of information and perspectives. Some of the measures we look at to assess the labour market and full employment are summarised in
Graph 8. This graph shows where these measures are currently compared with history. Currently, we
assess that most labour market indicators are still looking ‘tight’ relative to historical
norms. Model-based estimates of full employment also suggest that conditions are still tight. But the
labour market has eased and is closer to full employment than in late 2022, when we think it was at its
tightest in the past two decades. This easing in the labour market reflects the slowdown in economic
growth I discussed earlier. Adding to this, labour supply has increased, boosted by elevated population
growth and record high participation in the labour force. Graph 8 In addition to spare capacity in the labour market, we also make assessments of demand relative to the
economy’s capacity to supply goods and services (which is also referred to as potential output).
Like full employment, potential output cannot be measured directly, and so we also use a range of
indicators. Looking at these measures, we assess that current demand exceeds potential output. Similar to
developments in the labour market, though, the recent slowing in economic growth has lessened the gap
between demand and supply. Looking ahead, we expect the labour market to slow in response to the softening in economic growth
(Graph 9). We expect much of the adjustment in the labour market to happen through a decline in
average hours worked. And, while employment is expected to continue to increase, for a time it is
expected to do so at a slower rate than the increase in the working-age population. This means that the
unemployment rate is expected to increase, though it is still forecast to remain at low levels relative
to the past couple of decades. Graph 9 This easing will contribute to bringing the labour market broadly in line with full employment. Subdued
economic growth will also help bring demand and supply in the economy back into balance. We will continue
to share our assessment of how conditions in the labour market stand relative to our view of full
employment. Improvements to transparency I’d like to finish up by highlighting some of the recent changes we have made to improve the
transparency of our forecasts and assumptions. These changes will provide greater insights into our
economic assessment and a richer view of the inputs to the monetary policy decision-making process. This
improved transparency is aligned with the recommendations of the RBA Review, as well as the recently
updated Statement on the Conduct of Monetary Policy . Here are three key changes we’ve made I’d like to highlight: First, as I mentioned earlier, we’ve remodelled the Statement by revising its
structure, improving its flow and adding an overview that highlights the narrative leading to the
policy decision. We’ve also added a high-level summary to help readers access the key
information at a glance. Second, we have published our assessments of potential output and full employment in the Statement . From here on, these will be a regular feature of the publication. Third, we have increased the availability and accessibility of forecast data. This includes
increasing the range of forecast variables and assumptions published in the Statement .
Data files of historical forecasts are also being published in an easily downloadable format. We hope
this will help to stimulate external research that could be beneficial to the wider community of
economists. I imagine this audience will be keen users of these data! We have also committed to regularly publish an evaluation of the staff forecasts. Each year, we conduct an
internal review of the RBA forecasts and insights from these reviews have been published for the past two
years in the November Statement. We’ll continue to do so going forward. We’ll
also continue to publish insights from our business and community liaison program as we have been doing
since late 2022. Conclusion To sum up, inflation is coming down, but it is still high and it will take some time before it is back in
the RBA’s target range. Inflation is expected to decline to be in the RBA’s target range of 2–3 per cent in 2025 and to reach the midpoint of
2.5 per cent in 2026. This decline is based on the central projections that the subdued
economic growth that we have forecast will balance demand and supply of goods and services and that in
the next couple of years the labour market will be around levels consistent with full employment. Risks
remain though and as you’d expect we will continue to monitor incoming data closely. I also hope you will find the sizeable changes to the Statement and the enhanced
transparency useful. These changes are a step in a continuous evolution, and like our forecasts, our way
of communication will continue to develop. Thank you for your time. Endnotes I would like to thank Ashwin Clarke for
invaluable help in preparing these remarks and Susan Black, Fiona Georgiakakis, Callum Hudson,
Tom Rosewall and Declan Twohig for their comments and assistance. [*] Kohler M (2023), ‘ The Outlook for the Australian Economy ’,
Speech at UBS Australasia Conference, 13 November. ¹ Bullock M (2023), ‘ Monetary Policy in Australia: Complementarities
and Trade-offs ’, Speech at the Commonwealth Bank Global Markets Conference, Sydney,
24 October. ² Kohler M (2023b), ‘ The Outlook for the Australian Economy ’,
Speech at UBS Australasia Conference, 13 November. ³