Why Is Wage Growth So Low?

https://www.rba.gov.au/publications/bulletin/2015/jun/pdf/bu-0615-2.pdf

  • stronger growth in labour productivity has worked to contain growth in labour costs
  • Declining wage growth reflects spare capacity in the labour market, a decline in inflation expectations, a lower terms of trade, and the need for the real exchange rate to adjust to improve international competitiveness.
  • Decline in ToT and fall in mining investment mean that the economy requires a lower exchange rate, which has been in part delivered by low wage growth
  • However, statistical models also indicate that these factors cannot account for the full extent of the decline in wage growth, and elements such as an increase in the flexibility of wages to market conditions may also have contributed
  • The size of the decline in wage growth is larger than simple historical relationships suggest

The decline in wage growth

  • Wages are the largest source of household income and the largest component of business costs, and thus have severe implications for CPI
  • The pace of wage growth has slowed to late 1990’s levels
  • Suggestions that this might be the longest period of wage growth since the early 1990’s recession
  • Rate of annual wage growth declined to pace of inflation, 2-3%
  • Growth in the labour cost of producing a unit of output (unit labour costs) has also thus declined since 2012
  • The level of ULC’s has been little changed for more than three years- the longest period since the early 1990’s
  • International wage growth has been lower than forecast for several developed countries in recent years, including some where the labour market has tightened in capacity
  • The extent of the forecast of wage growth is large in the context of OECD countries

Wage growth and unemployment

  • In the short run, lower wage growth is associated with higher rates of unemployment
    Phillips curve.JPG
  • Firms experiencing subdued demand for G/S will seek to contain costs
  • Since wages tend not to adjust quickly to lower growth in labour demand, firms initially contain labour costs by laying workers off, reducing hours, or reducing hiring.
  • As capacity in the labour market rises, employees become anxious about job security and become willing to accept lower wage growth as there are fewer opportunities for alternative employment and more competition for job vacancies
  • The decline in wage growth is unusually large compared to the increase in the unemployment rate
  • Based on average relationship between 1998-2012, WPI growth has declined by more than twice as much as would be expected

Inflation expectations

  • Wages have fallen as sharply as they did in earlier episodes that had larger and sharper increases in the unemployment rate
  • This suggests that wage growth may be lower for a given rate of unemployment than in the past (the Phillips curve may have shifted inwards)
  • The shifting of the Phillips curve may be induced by inflationary expectations
  • Since employees are ultimately concerned with the purchasing power of their wage rather than its monetary value (concerned about real as opposed to nominal income), lower wage growth might be explained by temporarily lower inflation expectations for consumer prices
  • Expectations of inflation appear to have a cyclical component that might feed back into wage outcomes
  • These expectations are sourced from bond yields, union surveys and market economist surveys
  • However, even accounting for lower expectations, real wage growth from the perspectives of consumers has declined markedly, to around zero
  • This suggests that inflation expectations account for only a small part of the decline
  • Further, expectations tend to decline during periods of unemployment, so it is unlikely to explain why the decline in wage growth has been unusually large

Output prices and the Terms of Trade

  • Normally output prices in the economy are closely related to the prices consumers pay for G/S, so firms and households would have similar inflation expectations.
  • However, when there are changes in the Terms of Trade, the prices that firms receive and the prices that consumers pay can deviate substantially
  • The rise in the ToT during the mining boom saw many output prices increase by more than consumer prices – particularly true of mining prices, and industries that service mining extraction and investment (business services and construction)
  • For these firms, higher output prices meant that nominal wages could rise while also increasing profits
  • Facing higher prices and a relatively tight labour market, higher wages would attract scarce labour and increase output
  • Result was that increase in wages benefitted employees by more than they cost employers
  • That is, real wages from the perspective of employers fell relative to real wages from the perspective of households
  • 2002-2012: real producer wage declined overall, while real consumer wage increased by 10%. Since 2012, real consumer wages have seen little growth, whereas real producer wages have increased sharply
    • real producer wage: the cost to employer’s of purchasing an hour’s labour
  • Strong growth in output prices up to 2012 meant that firms could afford higher unit labour costs. With a rising ToT and increased mining investment ULC growth averaged close to 4% (excepting GFC). This was well above the average of 2% held in the 90’s, the first decade of inflation targeting.
  • Growth in ULC can be broken into growth in output prices and changes in the share of income being paid to labour
    • Strong growth of ULC’s over 2000’s attributed to faster pace of growth in output prices, while labour share of income actually fell slightly (strong growth in ULC was outpaced by stronger growth in firm’s margins)
    • Similarly, slower growth in ULC recently can be explained by slower pace of growth in output prices, while the labour share of income has increased slightly

The real exchange rate

  • The real exchange rate expresses prices or costs relative to those of our trading partners in common currency terms and provides one indication of an economy’s competitiveness
  • One measure of the real exchange rate is based on relative ULC (RER depreciations either by way of a depreciation in nominal exchange rae or a decline int hat economy’s relative prices or costs)
  • Over the decade to 2012, the ULC measure of the RER appreciated markedly. This reflect an appreciation of the nominal exchange rate of about 50% and an increase in Australia’s ULCs relative to our trading partners of almost 30%
  • The recent decline in ULC growth has helped Australian competitiveness
  • The ULC measure of the RER has depreciated around 12% since 2012, due to both a lower nominal exchange rate and to an extent a decline in Australia’s ULC relative to our trading partners. In turn, this has helped us adjust to a lower ToT and falls in mining investment
  • The ULC measure of the RER remains about 20% higher than when the ToT was at a similar level in 2006

Estimating the contributions: A Phillips Curve Model of Wages

  • The model attempts to explain wage growth using the unemployment rate, expectations of CPI, and inflation outcomes for firms
  • Historical relationships suggest that rising unemployment, lower inflation expectations and the decline int he TOT can explain 2/3 of the total decline in wage growth in the past few years
  • Other factors:
    • shifts in the bargaining power of labour: difficult to quantify, but inflation expectations for unions have shifted by more than some other measures and union wage expectations are also at historic lows. Liaison reports indicate that secular influences from technology and competition from offshore labour may explain the weakness in wage growth in some sectors
    • Low wage outcomes for public sector agreements in recent years may also have indirectly affected wage bargaining in the private sector – especially as many firms benchmark their wages to industry-wide wages. This is seen particularly in the health and education sectors.
    • The rise in the unemployment rate may have understated the extent to which spare capacity has developed in the labour market. For example, greater labour market flexibility may be allowing firms to adjust to hours rather than heads by more than usual. Alternatively, there may have been a larger-than-usual decline in labour force participation.
    • Wage may have grown more flexible. System of wage bargaining has become more flexible, individual employment contracts more prevalent in industries exposed to declines in resource prices/investment, (mining and business services)
    • The long span of the episode: a higher portion of employment contracts have been renegotiated during this period of subdued demand conditions. The typical length of an EBA (enterprise bargaining agreement) is three years, therefore, all EBA’s have been renegotiated with lower WPI. By comparison, over 2008-2009 a lower proportion of agreement were renegotiated, covering fewer employees

Assessment/Outlook

  • below average growth in economic activity has subdued growth in labour demand, which has resulted in an increase in spare capacity in the labour market
  • At the same time, expectations for CPI have moderated to below average
  • The decline in the ToT and mining investment have placed pressure on firms to contain costs
  • Thi has in part unwound the relatively strong inflation in Australian ULC’s over the period of the mining boom, which was part of the economy’s adjustment to the domestic income boost from the higher ToT
  • Had wage growth not declined over this period, employment growth may have been more subdued than actually observed, and unemployment higher, which may have weighed yet further on aggregate demand
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