April 08, 2024

Refining the balancing act: employment vs low prices

Reserve Bank says four key indicators have greatest predictive power to estimate wage inflation

The Reserve Bank’s Analytical Note accepts that many of its usual labour market indicators performed poorly during the COVID-19 years.

On 25 March 2024, the Reserve Bank of New Zealand (RBNZ) published recommendations concerning improvements it could make to its measurements of inflationary heat in the labour market. This is an issue that has worried many, considering our current economic environment. 
A common, although contested, understanding in economics is that high employment leads to higher inflation. Consequently, to keep inflation under control, we require a certain level of unemployment. That is the premise for the idea of a maximum sustainable employment rate.

Our economic ‘Goldilocks’ zone relies on a proportion of the working age population being out of work to keep prices down across the economy

The concept was discussed in a documentary about the economic changes, implemented by the fourth Labour Government, known colloquially as ‘Rogernomics’. Politicians then campaigned on the promise to keep inflation low by requiring a higher level of unemployment. It is also a promise that has re-emerged over the past couple of years in the aftermath of COVID-19; we need higher unemployment to curb the runaway inflation that we have been experiencing since 2020. 

RBNZ’s recent Analytical Note discusses this concept, known as the ‘Non-Accelerating Inflation Rate of Unemployment (NAIRU)’. The NAIRU is the proposed level of unemployment needed to maintain low and stable inflation. When unemployment falls below this rate, the theory suggests that it becomes more difficult for businesses to find and hire new staff. This, in turn, puts upward pressure on wage growth. When people have more money to spend in the economy, prices rise. This is sometimes known as the ’wage-price spiral’.  

The RBNZ has a mandate, set by the government, to keep inflation between one and three percent. As part of the RBNZ’s role to implement monetary policy they monitor the labour market to measure and assess indicators of inflationary pressure.

The current mandate was set in 2023 by the incoming National Government. Before then, the RBNZ had a dual mandate, which was introduced by the Labour Government in 2018. Under the Labour Government, the RBNZ was expected to keep inflation low, but they were also expected to keep unemployment low.

To many politicians, pundits, and commentators, those two mandates sat in conflict with each other

Essentially, the RBNZ was being asked to maintain a balance and set monetary policy to ensure that keeping inflation low was not achieved at the expense of New Zealand’s workforce. 

Currently, the RBNZ monitors a range of 44 indicators and compares them with their strongest or weakest levels since 2000. The RBNZ’s Analytical Note looked at 20 of these indicators and ranked each based on how well it predicts price and wage inflation. While the final recommendations suggest keeping the full set of 44 indicators, the Note also recommends that inflationary pressure from the labour market can be monitored using a narrow set of four high-quality indicators. Therefore, it is recommended that the full set of 44 indicators be largely used as an add-on to sit alongside the four key indicators for understanding the broader context of the labour market.

The four key indicators with the greatest predictive power to estimate wage inflation according to the RBNZ are:

  1. The job transition rate (the share of workers switching between jobs)
  2. The job vacancy-to-unemployment ratio
  3. The unemployment rate, and
  4. A survey measure of labour as a limiting factor for business production.

Previously, wage growth has generally been used by economists to forecast future wage growth

It is interesting that wage growth itself is not one of the four key measures, and, additionally, there is no distributional analysis within the chosen measures. A question that’s important for minimum wage setting and tax changes is whether wage growth for higher-income earners is more inflationary overall than wage and job growth for lower-income earners.

Finally, it is interesting to note that these recommendations from the RBNZ have come after the end of their dual mandate. Therefore, it could be argued that this is the RBNZ’s way of indicating that employment is still of consequence to them and is a factor that will influence the setting of interest rates.