Authored by Kieran Davies, Chief Macro Strategist, Coolabah Capital Investments.
The RBA is committed to keeping easy monetary policy in place until it meets its ambitious goal of achieving full employment. On Coolabah Capital’s calculation, full employment equates to an unemployment rate of 4¾%, where uncertainty around this rate ranges from 4 to 5½%. The RBA’s estimate in the low 4s is at the lower end of the range and is heavily influenced by pre-pandemic experience where unemployment had to fall to very low levels both here and abroad to finally boost wages and inflation. At this stage, the pandemic does not appear to have affected full employment, although the ageing of the population continues to trim structural unemployment.
With the Reserve Bank of Australia (RBA) committed to reaching its legislated “full employment” objective in order to finally return inflation to its 2-3% target band, full employment can be approximated by what economists awkwardly describe as the “non-accelerating inflation rate of unemployment” (NAIRU). The NAIRU is unobservable and must be inferred from the behaviour of wages, prices and unemployment, where wage growth and inflation pick up if unemployment falls below the NAIRU and slow down if unemployment exceeds the NAIRU.
Given its importance to the future course of policy, Coolabah Capital Investments (CCI) has in a new research paper (click on that link to download) estimated a slightly modified version of the RBA’s model of the time-varying NAIRU. This model puts the NAIRU at about 4¾% in early 2021, although the significant uncertainty around this point estimate is reflected in a confidence interval that ranges from 4% to 5½%. Experimental individual state government NAIRUs yielded similar results when combined to approximate the national rate.
According to CCI’s analysis, the NAIRU has fallen by about 1½ percentage points (pp) since 2000, with the NAIRU below the actual unemployment rate for just over a decade. This persistent spare capacity is currently subtracting about 0.6pp from annual inflation in the low 1%s. The lower NAIRU partly reflects the ageing of the population, which accounts for 0.3pp of the overall decline since 2000. The increase in the eligibility age of the age pension and the difficulty in saving for retirement in a low-interest rate world should reinforce this downward pressure on the NAIRU in the years ahead.
In contrast, there does not appear to be material scarring of the labour market from the pandemic that would raise the NAIRU. The labour supply has quickly rebounded, although a slight increase in long-term unemployment bears watching. The closure of the border could lead to skill shortages, although we could not find a role for immigration when extending the model. Critical migration-related shortages may still develop, though we note that companies have kept wages in check over recent years despite many firms consistently reporting significant difficulty in finding suitable staff.
The RBA’s current estimate of the NAIRU in the low 4%s is at the lower end of CCI’s range, while the Commonwealth Treasury’s estimate of 4¾% is at the midpoint. The lower RBA estimate may reflect an updating of the model and/or a slight difference in estimation periods, but, more critically and correctly in our view, it is clear that the RBA is applying judgment when using inherently uncertain NAIRU estimates. Governor Lowe is strongly influenced by the pre-pandemic experience, where, like its peers, the RBA overestimated the NAIRU in the wake of the global financial crisis, leading it to consistently overestimate wage growth and inflation.
These forecasting misses have led the RBA and other central banks to focus on “nowcasting” the economy and adjusting monetary policy based on actual wage and inflation outcomes rather than uncertain forecasts. The RBA would also recognise that the unemployment rate likely has to fall below the NAIRU for a time to ensure a sustained recovery in wages and inflation. The RBA may be reluctant to make this point publicly, but the lower NAIRU estimate plays a valuable role in signalling to financial markets its determination to keep policy accommodative for as long as needed to reach its goals.
CCI believes that all serious fixed-income investors should have their own internal NAIRU estimates if they want to allocate capital based on their expectations for future interest rate changes. This in turn requires a credible macro-econometric capability.