When should budget repair start? Australia’s treasurer reckons we should go back to our national pastime — worrying about deficits — when the unemployment rate hits 6%.
There’s only one problem with that. The budget documents say unemployment won’t be low enough to generate wages growth and inflation until it is down to 5%. That gap matters.
Here’s how the fiscal strategy is described:
The COVID-19 economic recovery plan will focus on achieving a strong recovery to quickly drive down the unemployment rate. This phase will remain in place until the unemployment rate is comfortably below 6%.
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But it should keep going until the unemployment rate is lower. Here’s why.
It’s all about the NAIRU
The estimate of the level of unemployment that causes inflation is a key input to economic policy.
This is important to understand. There’s a trade-off between inflation and unemployment. The reason we don’t aim for 1% unemployment is evidence that would lead to damaging inflation. Keeping some unemployment in the system is the price we pay for avoiding inflation.
The Reserve Bank of Australia (RBA) will usually start raising interest rates when inflation gets down to around the level that creates a risk of inflation. This number is called the NAIRU, or the “non-accelerating inflation rate of unemployment”.
So what is the NAIRU? This text appears in budget paper 1.
Spare capacity in the economy is expected to be absorbed over about five years. Over broadly the same timeframe, inflation is expected to return to the midpoint of the RBA’s inflation target band and the unemployment rate is expected to gradually converge to 5%, the estimate of the NAIRU.
That made my eyes pop open. Wasn’t the NAIRU estimated to be lower than that just last year?
A little is a lot
The estimate of the NAIRU has been a source of contention in recent years. The RBA’s Luci Ellis spoke about it in 2019 and said this:
We can’t directly observe the NAIRU — we don’t know exactly where it is — but we can infer how far above or below it we are from the behaviour of wages growth and inflation.
Australian inflation has been very much missing in action recently as we all know.
“We have therefore gradually revised down the estimate of the prevailing NAIRU from 5.25% a few years ago to 4.5% now,” Ellis said.
That’s different from the budget estimate — 4.5% and 5% might look close to each other, but in a population like ours a little is a lot. The difference is about 70,000 people out of work.
Even that 4.5% figure might be too high. The RBA puts an error band around its NAIRU estimate that includes numbers from 3.8% to 5.5%.
I find the lower numbers much more convincing. The United States has managed unemployment around 3% without any signs of inflation.
And anyway, the RBA has given us wages growth and inflation well below average for ages. Erring a bit on the high side for a time wouldn’t be the end of the world.
A risk of austerity
There are two problems here. First is that it is economically absurd to have daylight between your estimate of the NAIRU and the point at which you start withdrawing fiscal support. They should be the same number.
If you reckon we won’t get wages growth until we’re down to 5% unemployment, don’t pull the rug out until we’re down there.
Second is this sudden shift in the estimated NAIRU. Why is it suddenly higher? Have the recessionary conditions changed the labour market such that it is higher?
If so this should be made explicit because otherwise it starts to look like it is being massaged upward by a government salivating at the chance to return to its traditional menu of budget rectitude, aka austerity.