Why the Reserve Bank is pushing us towards a recession that we don't need to have - ABC News  Ian Verrender   13 Feb 2023

Gloomy times could be ahead for Australia's economy if sharp rises in interest rates don't have the desired effect.

What if you woke up one morning only to be told the very essence of everything you believed in was wrong?

And what if those beliefs — and the decisions you made based upon them — underpinned the living standards of millions of people, here and around the world?

That's the reality dawning on a generation of economists who suddenly have been beset with doubts about one of the great tenets of modern economic theory: the relationship between jobs, wages and inflation.

It is a theory that has been one of the driving forces behind the way most developed nations manage their societies and it has been a pillar of central bank policy for more than 60 years.

Known as the Phillips Curve — after New Zealand economist, William Phillips, who first formulated it in 1958 — it maintains that as more people find work, pressure builds on wages, which then leads to higher prices and ultimately entrenches inflation.

Why the RBA is playing with fire  RBA governor Philip Lowe and his colleagues must decide how deep a recession they are prepared to wear, writes business editor Ian Verrender.

It has a neat logic to it. As labour becomes more scarce, the price of labour rises which then flows through into higher prices for goods and services more generally.

Given their primary remit is to control inflation, it's been the credo to which all central banks have subscribed. Until now.

For whatever reason, the relationship between unemployment and inflation has become less clear across the developed world.

In the lead up to the pandemic, wages growth was the slowest on record —even as unemployment eased and interest rates plunged. In the aftermath, jobs numbers inexplicably have remained strong despite surging prices and interest rates.

That's left central banks looking confused. And it has created an enormous quandary.

If the fundamental basis for economic management is now in doubt, there is a risk that almost every major central bank — in their quest to kill the inflationary spike — could be about to unnecessarily throw millions of workers out of a job by doubling down on rate hikes.

Dole bludger or victim of conspiracy?

An unemployment rate of about 5 per cent was long considered ideal for our economy's wellbeing.

Until the 1970s, the idea of full employment meant exactly that. Governments aspired to have everyone employed.

But William Phillips' theory changed all that. After the global inflationary surge of the time, a new idea gained traction in the halls of power.

What we needed, it was decided, was a largish pool of unemployed workers to ensure we kept wages and inflation in check. As an added bonus, they provided fodder for the tabloids which — for a bit of theatre to boost sales — delighted in labelling them welfare cheats and dole bludgers.

How owning a home got harder through the generations  With more interest rate rises on the cards on Tuesday, and potentially later this year, the journey towards home ownership will take far longer.

The thinking became so entrenched, that mainstream economists and central banks developed a neat little acronym for working out just how many poor individuals we needed on the employment scrapheap. They called it the NAIRU — the Non Accelerating Inflation Rate of Unemployment.

For decades, it was believed we needed an unemployment rate of about 5 per cent just to keep everything ticking along nicely.

But as the relationship has broken down, an outright war amongst the heavyweights in economic thought has erupted about where we go from here.

Former International Monetary Fund chief economist Olivier Blanchard kicked off the debate, arguing rate hikes were an inefficient way of dealing with price rises and pushed instead for more intervention by governments.

He's been backed up by a host of well known economists including former US Federal Reserve economist Claudia Sahm.

"Outrageously, we leave fighting inflation to the Fed alone," she wrote. "An unelected, unaccountable group who decides who wins and loses."

She has been marshalling colleagues, calling for the US Fed and other central banks to junk the Phillips Curve ideology. 

Federal Reserve chairman Jerome Powell has overseen a series of interest rate rise in the US over the past year. 

Last month, the US economy was rocked by some unwelcome news that sent financial markets into a mild state of panic.

Despite the punishing raft of US interest rate hikes in the past year, American unemployment dropped to a 54 year low of just 3.4 per cent, just one point below ours which, at 3.5 per cent, is the lowest on record.

It was news that rattled the US Fed. For the thinking goes, if one believes in the Phillips Curve, that for inflation to be truly tamed, unemployment must rise. More people need to be out of work.

Who's profiting from the inflation crisis?   Here's the fundamental economic problem we now face as a nation: It seems, as time moves on, it's businesses that are further fuelling inflation — not consumers. 

The only way to achieve that, according to Phillips Curve advocates, is to push interest rates even higher, to force the US economy, and the rest of the world for that matter, into a deep recession. Hence the panic on financial markets.

The debate may be raging like wildfire amongst economists and academics but amongst the world's biggest central banks, no-one is listening.

Most, including our own Reserve Bank of Australia and the US Federal Reserve, are still fervent believers in William Phillips' neat little curve, and accompany each rate hike with a fearful three word soundbite; the "wage, price spiral".

They have some heavyweight backers. On the other side of this debate is former US Treasury Secretary Larry Summers who has been a vocal proponent for ever more punishing rate hikes, claiming inflation won't be broken while record numbers of workers remain employed. 

According to Professor Summers, US unemployment would need to hit 6 per cent to kill the inflation genie.

Why doesn't the theory hold any more?

There's no simple answer to that. Many have argued over the years that it often has been found wanting.

But the primary problem is that the world has changed dramatically since it first became popular as workers' rights have been eroded. They no longer have the same kind of bargaining power they once had.

In Australia, you can't just walk off the job in protest at your pay and conditions in the way workers in the 1970s did. You need court approval to take industrial action.

That's obliterated the number of disputes and strikes that once plagued the economy as the graph below shows. And under our enterprise bargaining system, pay is negotiated over several years, keeping wages subdued for extended periods.

Source: Australian Bureau of Statistics

There are other factors at work too. Technological change has altered the jobs market, with more automation while the continued importation of foreign workers has also kept a lid on wages.

Even now, wages growth is running at way below inflation, meaning most workers are taking a real wages cut while simultaneously being whacked by the most punishing round of interest rate hikes in history.

China, Australia and the isolation game  Despite the official statements assuring that relations between China and Australia were heading in the "right direction", but relations seem to remain stalled, writes Ian Verrender. 

To its credit, the RBA has tweaked its rhetoric on wages and inflation and for several months has referred to the "prices wages spiral".

It's a nod to the fact that the current bout of global inflation wasn't caused by a wages blowout from militant workers. It was supply disruptions of goods and commodities in the wake of the pandemic and Russia's invasion of Ukraine that lit inflationary bonfire.

Since then, the chorus from central banks globally is that the inflationary pressures are easing as energy and commodity prices return to more normal levels and declining shipping costs have helped ease materials shortages.

But like their global counterparts, the RBA remains fixated on the notion that if jobs numbers remain strong, inflation could become entrenched, which has only hardened its resolve to keep pushing rates higher.

Eventually, they'll get there. Higher interest rates at some stage will curb spending, cut profits and result in mass layoffs.

It could well be recession we didn't have to have.