Productivity, Wages, and Inflation: The Tug-of-War Shaping Australia’s Economy

There has been a shift in the conversation amongst the economics fraternity in Australia recently. Only a few short months ago, inflation was falling and economists were united in expecting further cuts to the RBA cash rate. That expectation has now changed. 

When the Q3 inflation report was released by the Australian Bureau of Statistics in late October it confirmed hints that first appeared in the August monthly inflation figures that price pressures were again rising in the economy. The RBA – whose job it is to keep inflation at 2.5% on average over the medium term – pointed to market services and new home construction costs as areas of particular concern. 

Price moves for services can provide clues about the balance of supply and demand in the local economy because services are less likely than goods to be internationally traded and tend to have a large wages component in their cost base. Australia’s historically low unemployment rate is giving workers enough bargaining power to see wages grow at 3.4% p.a. The problem with that is that, in the absence of productivity growth, the Australian economy can’t sustain wage growth that fast and also keep growth in prices at the 2.5% target. 

Productivity grows when we produce more outputs for a given number of inputs. Every economy has a ‘scarcity’ problem when it comes to inputs (referred to by economists as the factors of production) because there is only so much land, labour and capital that can be employed to produce goods and services. Productivity grows when we combine those resources in more effective ways through better management practices, better technology, providing more labour-saving tools or improving the skills of the workforce.  

Australia has had precious little productivity growth since 2016, which basically means that the only way to improve our living standards is by working more hours or by being fortunate enough to see the price of the things that we sell to the world rise in comparison to the price of the things we buy. Both of these things have happened since the onset of Covid19, providing households with a cushion against a cost of living crisis that would have otherwise been worse. 

Now that the jobs market is gradually weakening and the price of things that Australia sells are no longer rising relative to the price of the things we buy, productivity growth has become all the more important. The RBA really only has one tool to keep inflation pressures contained while it hopes that productivity growth makes a comeback, which means that markets are now expecting the Reserve Bank to keep interest rates unchanged well into 2026 to prevent the economy from running too hot and stoking inflation pressures further. 

RaboResearch still has one more 0.25ppt rate cut in our forecast but we don’t expect that to arrive before May of next year, if it arrives at all. 

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