Australia | Jul 23 2007
By Greg Peel
Mind the output gap.
That’s the advice from the economists at the Commonwealth Bank. Comm Research suggests that a strong Australian economy coupled with low unemployment will not necessarily lead to uncomfortable inflationary pressure. Yet this is precisely what the RBA is concerned about.
It stands to reason that if business is booming, and everyone has a job, there will be upward pressure on wages which will in turn affect upward pressure on the prices of everything from houses to bananas. This is classic demand-side inflation. While there has already been upward pressure on prices which have led to recent interest rate rises, driven largely by strong global commodity prices, the RBA has been somewhat surprised by the lack of an obvious jump in wages in a virtually “fully” employed economy.
But the demand-side will only provide an inflationary influence as long as it outruns the supply-side. The price of a widget will increase if widgets are highly sought after and there’s not enough to go around. But if widgets are highly sought after, and widget makers can comfortably increase their supply, then there’s no reason for the price of a widget to rise.
Comm Research makes note of what has been a common theme in this protracted commodity price rally – the world has been caught short by the rise of China and other emerging economies and has had to scramble to bring capacity up to meet the step-jump in demand. This is not an overnight phenomenon. It is clearly evident that despite the enormous surge in commodity prices, resource-rich Australia has still struggled to post much more than a flat trade balance to date. There have not been enough existing mines and oilfields to provide production enough to satisfy demand. There are major constraints at rail and port facilities. No matter how much they want to, resource companies have not been able to get enough “stuff” out to the buyers in any expedient time frame. As a result, the value of the commodity price boom has not shown up in the terms of trade in Australia when adjusted for the limitations on sales. And we keep importing more and more goods as Chinese deflation brings the prices of imports down.
But while Australian industry may have nodded off on the couch during the demand-poor past decades, activity is well and truly back in full swing. Comm Research notes private investment spending has run at between 6% and 17% growth over the past four years, and public spending has grown at 7-9%. Recent state budgets suggest there is plenty more capital works spending to come.
“The bottom line is that our capital stock will grow at the fastest rate seen since the 1960s,” the economists suggest.
While the world is largely in agreement that there is no end in sight to the China story (which includes other emerging economies) and as such demand is unlikely to falter, analysts have been suggesting for the last couple of years that the supply side will surely catch up. Analysts have been constantly pushing the magical catch-up date out to the future as all sorts of problems have emerged in the catch-up, ranging from the capitulation of old machinery to extended worker strikes. Nevertheless it’s been all hands to the pump, and catch up the supply side soon will.
In Australia, as in most of the developed world, the catch-up problem has been further exacerbated by a simple lack of workers, be they professionals or general hands. At 4.2%, Australia’s unemployment rate has fallen to its lowest in thirty years, suggesting employment is close to “full”. That is, everyone who wants a job already has one, and as such if you open a new mine or build a new factory, who are you going to get to man it? In the meantime, this period of high commodity prices may well pass us by. The only option left open is to offer a higher wage than the next company while profit margins provide such an opportunity.
This is exactly what the RBA has been worried about. If wages grow as a result of lack of labour supply then this not only increases the cost to industry (thus pushing product prices up) but also puts more money in pockets to be spent on buying “things”. Ergo, Australia suffers wage-led inflation. However, the RBA has been surprised of late that evidence of such wage rises has not emerged.
Again, Comm Research turns to the supply side.
Australia’s immigration rate is now at the highest it’s been in fifty years, and an increasing proportion of those immigrants are “skilled”. Labour force participation is at a record high. This means that there are proportionately more Australians sticking their hand up for a job. There are an increasing number of single parents who need to work. There are an increasing number of families who need two incomes in order to pay the mortgage. There are an increasing number of seniors remaining, with encouragement, in the workforce beyond the traditional retirement age. There are more welfare recipients being required to work for their benefits. And the birth rate is growing modestly, so there are more children to ultimately send down the mines.
Thus when one considers the level of unemployment in Australia, one must consider that housewives, for example, are not counted as unemployed. Thus a whole group of individuals can join the workforce without moving the unemployment figure, and the increased supply will help to alleviate wage rise pressures.
The conclusion is thus that with the supply side rising to meet the demand side, inflation is not as much as a given as might otherwise appear the case. Comm Research also notes that with capital spending growth running ahead of labour force growth, the likely result is increased productivity. This is another inflation-friendly development.
The economists also make note of the “output gap”. Over to Investopedia.com:
“An economic measure of the difference between the actual output of an economy and the output it could achieve when it is most efficient, or at full capacity. There are two types of output gaps: positive and negative. A positive output gap occurs when actual output is more than the full-capacity output. Negative output gap occurs when actual output is less than full-capacity output.
“The measure compares the actual GDP (output) of an economy and the potential GDP (efficient output). When the economy is running an output gap, either positive or negative, it is thought to be running at an inefficient rate as the economy is either overworking or under-working its resources. Economic theory suggests that positive output gap will lead to inflation as production and labour costs rise.”
As the graph below indicates, Comm Research is forecasting the output gap to move into negative territory in the next few years. The result is that Australia’s economy should be quite able to remain strong without there being a fear of rampant inflation to spoil the whole ball game. And as such the RBA need not be looking at a long period of monetary policy tightening.
There are risks to this scenario however, Comm Research notes. As Australia’s housing boom has retreated, so has investment in property. Hence we are undergoing a rise in rents as supply, in this case, is failing to keep up with demand. This will impact on inflation until such time as property investment can catch up. The other concern is one of FNArena’s favourite subjects – food prices. If it is true we are witnessing a secular jump in food demand and prices, then this will also be inflationary.
