New Zealand’s ‘Output Gap’

A good example of the output gap from the RBNZ Monetary Policy Statement last week – see graph above. There are strong capacity pressures which are the result of the unleashing of domestic demand and supply chain disruptions. Although the latter has increased it is presently unable to keep up with the the overall aggregate demand of the economy and subsequently this has driven inflation up to 4.9% above the 1 to 3% remit target band.

With unemployment at 3.4% and *underutilisation of 9.2%, annual employment growth of 4.3% (September 2021) cannot be maintained with this pressure on the labour market. There has been strong demand for more workers in some sectors, but it has been difficult for businesses to recruit extra staff. This has seen wages rise as firms compete for workers. However it is important to remember that on 29th October there were still 1,282,152 jobs being supported by a wage subsidy. A total of NZ$3,719.7 million had been paid via the COVID-19 Wage Subsidy August 2021. With the continued demand for labour, wage pressure and salary costs are expected to increase. Consequently a rising unemployment rate could be evident.

*underutilisation  – measures spare capacity in New Zealand’s labour market. People do not have a job, but are available to work and are actively seeking employment

Notes on the output gap

If there is no long-term trade-off, low inflation does not permanently choke growth. Moreover, by keeping inflation low and stable, a central bank, in effect, stabilises output and jobs. In the graph below the straight line represents the growth in output that the economy can sustain over the long run; the wavy line represents actual output. When the economy is producing below potential (ie, unemployment is above the NAIRU), at point A, inflation will fall until the “output gap” is eliminated. When output is above potential, at point B, inflation will rise for as long as demand is above capacity. If inflation is falling (point A), then a central bank will cut interest rates, helping to boost growth in output and jobs; when inflation is rising (point B), it will raise interest rates, dampening down growth. Thus if monetary policy focuses on keeping inflation low and stable, it will automatically help to stabilise employment and growth.

What is New Zealand’s NAIRU?

New Zealand’s unemployment rate has fallen 4.0% and with positive growth forecasts it will no doubt fall further. This low rate has meant that labour bargaining power has increased and the Labour Cost Index has risen to 2.2% and private sector average hourly earnings were up an annual 4.5%.

In the June quarter this year the participation rate was at 70.5%  one of the highest in the world – this shows how fully employed the NZ economy is. Many other countries have achieved falls in their unemployment rates, after the initial shock of COVID–19, but only as swathes of people gave up looking for a job. So how tight is the labour market? The RBNZ judged an unemployment rate of around 4.5% as being consistent with the notion of maximum sustainable employment without causing a rise in inflation. Economists refer to this as the NAIRU (non-accelerating inflation rate of unemployment), the rate of unemployment at which inflation remains constant.

The lack of workers from overseas has impacted these figures and a relaxing of border restrictions might ease labour constraints. However it can work the other way with labour leaving New Zealand and therefore a net loss of people. But at the moment the falling unemployment figures are very problematic and inflationary and the Reserve Bank Reserve Bank’s Monetary Policy Committee need to think about when and how it returns New Zealand to a more neutral interest rate – neither expansionary nor contractionary. The current OCR (interest rates) rate is 0.25% but the RBNZ has estimated that the neutral rate is between 1.5% and 4.5% which seems to suggest that it is still very expansionary. Therefore with unemployment set to fall and further inflationary pressure should see the RBNZ increase the OCR.

Source: BNZ Economy Watch – 4th August 2021

The NAIRU in New Zealand

Below is an extract from a RBNZ paper from March this year on Estimating the NAIRU and the Natural Rate of Unemployment. Especially useful for A2 students.

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The headline unemployment rate in New Zealand has been trending down over time. This fall in the unemployment rate has not been accompanied by a rise in inflation, suggesting that the underlying natural rate and the NAIRU may have also declined through time. In this section, we document some of the changes in the New Zealand economy that have influenced the unemployment rate over history.

As a first step, we disaggregate the unemployment rate into three sub-components as follows:

a. Cyclical unemployment results from changes in aggregate demand conditions over the course of a business cycle. As firms experience weaker demand, existing workers may be laid off and fewer new workers will be hired.
b. Frictional unemployment refers to the regular short-term churn in the labour market, both within, and in and out of, the labour force. It is determined by the efficiency of the matching process given the diversity of job-seekers and vacancies.
c. Structural unemployment represents a more fundamental mismatch between those hiring and job seekers given their skills and geographic location. This could arise from long-lasting changes in the structure of the economy such as socio-demographic trends, technological change, or a rapid change in the mix of industries.

The lines between these categorisations can be indistinct. For example, some argue that a prolonged period of cyclical unemployment could also lead to hysteresis effects that could spill over to structural unemployment. For example, an extended period of unemployment may lead to an erosion of human capital making workers less attractive to employers and hence reducing their bargaining power. In principle, frictional unemployment and structural unemployment should be captured by the trend in the NAIRU or the natural rate, as both forms of unemployment may continue to exist even if the labour market is in equilibrium. This is because those that are structurally unemployed may not be easily drawn back into employment despite an increase in labour demand and an upward adjustment in wages. In addition, the level of frictional unemployment is largely determined by the efficiency with which potential workers and employers can find jobs. In contrast, cyclical unemployment captures when the labour market may be operating below capacity as a result of a shortfall in demand.

Monetary policy has little influence over the level of frictional and structural employment. These are largely determined by the evolution of technology and the obsolescence of skills, and by structural policies to facilitate the acquisition of new skills and improve the match between employers and job-seekers. For example, policies that affect the cost of hiring (e.g. employment protection laws), the incentives for job finding (e.g. unemployment insurance), or the bargaining power of workers (unionisation and labour contract laws).

In Figure 3, we decompose the pool of unemployed workers on the basis of unemployment durations. In particular, we categorise those who have been unemployed for less than 4 weeks as contributing to frictional unemployment, 4 to 52 weeks as cyclical unemployment, and greater than 52 weeks as structural unemployment.

Is the Natural Rate of Unemployment in the US lower than economists think?

The natural rate of unemployment is the difference between those who would like a job at the current wage rate – and those who are willing and able to take a job. In the above diagram, it is the level (Q2-Q1).

Source: economicshelp.org

The natural rate of unemployment will therefore include:
Frictional unemployment – those people in-between jobs
Structural unemployment – those people that don’t have the skills that fit the jobs that are available.

It is also referred to as the Non-Accelerating Inflation Rate of Unemployment (NAIRU) – the job market neither pushes up inflation nor holds it back.

US Labour Market – tight but little wage growth.

The recent (February 2018) US Federal Reserve Monetary Policy Report stated that the US labour market appears to be near or a little beyond full employment. In theory this should suggest major labour shortages which ultimately end in higher wages for workers. Although employers report having more difficulties finding qualified workers, hiring continues apace, and serious labour shortages would likely have brought about larger wage increases than have been evident to date. The unemployment rate appears to be below most estimates of the natural rate.

January US unemployment rate = 4.1%
Congressional Budget Office’s (CBO) current estimate of the natural rate = 4.6%

The Unemployment Gap

The unemployment rate gap is the unemployment rate minus the CBO’s estimate of the natural rate of unemployment. The shaded bars indicate periods of business recession.

The median of Federal Open Market Committee (FOMC) participants’ estimates of the longer-run normal rate of unemployment and the CBO’s estimate of the natural rate of unemployment have both been revised down by about 1% over the past few years, one indication of the substantial uncertainty surrounding estimates of the “full employment” rate of unemployment.

The US Fed have suggested that with many advanced economies experiencing such low inflation that more persistent factors may be restraining price growth therefore the NRU could be lower in some countries than many economists think. Prices in many industries have been subdued due to technological changes – internet shopping which allows easy comparison – which restricts businesses ability to demand higher prices.

What could be the reasons for less wage growth?

• Employees need less compensation as the inflation rate has been low
• An increase in part-time employment
• Spare capacity in the labour market
• Employees keen on job security so put less emphasis on wage bargaining
• Increasing number of people participating in the labour force.
• Shorter working week
• Ageing and declining working age population

Although in the US there have been labour shortages in some areas of the economy, this hasn’t flowed through into the aggregate labour market. However speculation of higher inflationary pressure through higher wages has alerted markets that the US Fed may increase interest rates although they will remain reluctant to tighten too aggressively.

Source: US Federal Reserve Monetary Policy Report – February 2018.

Full v Fulfilling Employment

Just going through the Natural Rate of Unemployment with my A2 class and I remembered a post I did last year. Free Exchange in The Economist had an article which looked at the change in terminology used by Janet Yellen ex-chairman of the Federal Reserve. In a statement last year she alluded to the US economy near maximum employment and that rate rises could ensue. However only 69% of American adults have a job.

Full employment has normally been the concept that has been used to describe a situation where there is no cyclical or deficient-demand unemployment, but unemployment does exist as allowances must be made for frictional unemployment and seasonal factors – also referred to as the natural rate of unemployment or Non-Accelerating Inflation Rate of Unemployment (NAIRU). If a central bank wishes to stimulate demand below this level there is the concern that inflation will increase therefore they take a guess as to what is the natural rate of unemployment – the lowest rate of unemployment where prices don’t accelerate. Maximum unemployment is the same in that it refers to the labour market being as tight as it can be without increasing prices. Natural rates in the US have varied – around 5.3% in 1950 and then peaking at 6.3% in the stagflation period before falling 4.9% in 2008 and then rising to 5.1% after the GFC, see graph below.

NRU and its causes

The NRU mainly depends on the level of frictional unemployment – defined as those who are in between jobs. This number can vary as at different times of the business cycle as there can be a delay in matching those looking for work with the vacancies themselves – a mismatch sometimes referred to as Structural Unemployment. The increase in frictional unemployment in the 1970’s and 80’s was largely due to the decline in manufacturing jobs with the advent of automation and more right wing policies (Reagan and Thatcher). Workers would stay unemployed in the hope that good high paid manufacturing jobs would reappear.

Unions can also influence the NRU with protecting workers jobs and pushing up wages so that employers find it too costly to employ more labour. However the fall in the 1990’s could be due to the advent of technology in the hiring process and the growth of part-time jobs which assisted those workers facing a career change.

Another influence on the NRU is wage growth as with the higher wages you attract more of the labour force to engage in actively looking for work.

A central bank will have to use trial and error to make a decision on how much spare capacity there is in an economy. Only when prices start to increase do they have an idea how capacity is running.

Quality not Quantity

As alluded to by The Economist the goal of full employment must consider the quality of jobs as well. With the acceleration of technology over labour, maximum employment should consider more than capacity constraints or inflationary pressure.

Rather, governments need to consider the options available to workers: not just how easily they can find jobs they want, but also how readily they can refuse jobs they do not. By lifting obstacles to job changes and giving workers a social safety net that enables them to refuse the crummiest jobs, societies can foster employment that is not just full, but fulfilling.

Sources: The Economist 28th January 2017, St Louis Federal Reserve – Natural Rate of Unemployment

Don’t abandon the Phillips Curve

I have done numerous blog posts on the Phillips Curve some of which have discussed the missing trade-off between inflation and unemployment. Recent data from the US suggest that reducing rates of unemployment have not activated higher levels of inflation. US Fed Chair Janet Yellen has suggest that the level of unemployment is below the natural rate of unemployment (the lowest rate of unemployment where prices don’t accelerate) and that prices should soon rise. However inflation in the US is only 1.5% (target 2%) so does the Phillips Curve still apply? The Economist looked at another instance where this theory has failed.

2019 – after the financial crisis unemployment exceeded 10% and the excess supply of labour should have had significant downward pressure on prices. However prices were at 1.3% just below what they are today. Some economist explained this situation by an increase in the natural rate of unemployment (NRU) – 6.5% was a figure quoted by some economists. But today with unemployment now at 4.3% and inflation at 1.5% this theory does not seem to stack up. The Fed estimates that the NRU is between 4.7% and 5.8%.

Reasons not to abandon the Phillips Curve

1. The effects of unemployment on inflation can be distorted by one off events such as:
* the rapid decline in oil prices in late 2014
* the price of mobile data – firms have been offering limitless data which has also been   given a higher weighing in the inflation calculation. Mobile phone deals have shaved 0.2% off the inflation rate

2. It is possible with such low unemployment that inflation will eventually increase. This happened in the late 1960’s with unemployment under 4%, inflation rose from 1.4% in November 1965 to 3.2% a year later. By 1969 inflation was at 5%.

3. Self-fulfilling inflationary expectations could explain the low inflation rate. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Source: The Economist – 17th June 2017

The theory of the Phillips Curve and the NAIRU

Bill Phillips (a New Zealander) discovered a stable relationship between the rate of inflation (of wages, to be precise) and unemployment in Britain from the 1850’s to 1960’s. Higher inflation, it seemed, went with lower unemployment. To economists and policymakers this presented a tempting trade-off: lower unemployment could be bought at the price of a bit more inflation. However, Milton Friedman and Edmund Phelps (who both later picked up Nobel prizes, partly for this work), pointed out that the trade-off was only temporary. In his version, Friedman coined the idea of the “natural” rate of unemployment – the rate that the economy would come up with if left to itself. Now economists are likelier to refer to the NAIRU (non-accelerating inflation rate of unemployment), the rate at which inflation remains constant. The theory is explained below:

Suppose that at first unemployment is at the NAIRU, u* in the graph below, and inflation is at p0. Policymakers want to reduce unemployment, so they loosen monetary policy: that stimulates spending, so that unemployment goes down, to u1. Inflation rises to p1, along the initial short-run Phillips curve, PC1. But that raises inflationary expectations, so that workers demand higher wage increases and real wages rise again. Firms shed labour, returning unemployment to u*, but with a higher inflation rate, p1. The new short-run trade-off is worse, with higher inflation for any level of unemployment (PC2). In the long run the Phillips curve is vertical (LRPC).

Full v Fulfilling Employment

Free Exchange in The Economist had an article which looked at the change in terminology used by Janet Yellen chairman of the Federal Reserve. In a recent statement she alluded to the US economy near maximum employment and that rate rises could ensue. However only 69% of American adults have a job.

Full employment has normally been the concept that has been used to describe a situation where there is no cyclical or deficient-demand unemployment, but unemployment does exist as allowances must be made for frictional unemployment and seasonal factors – also referred to as the natural rate of unemployment or Non-Accelerating Inflation Rate of Unemployment (NAIRU). If a central bank wishes to stimulate demand below this level there is the concern that inflation will increase therefore they take a guess as to what is the natural rate of unemployment – the lowest rate of unemployment where prices don’t accelerate. Maximum unemployment is the same in that it refers to the labour market being as tight as it can be without increasing prices. Natural rates in the US have varied – around 5.3% in 1950 and then peaking at 6.3% in the stagflation period before falling 4.9% in 2008 and then rising to 5.1% after the GFC, see graph below.

NRU and its causes

The NRU mainly depends on the level of frictional unemployment – defined as those who are in between jobs. This number can vary as at different times of the business cycle as there can be a delay in matching those looking for work with the vacancies themselves – a mismatch sometimes referred to as Structural Unemployment. The increase in frictional unemployment in the 1970’s and 80’s was largely due to the decline in manufacturing jobs with the advent of automation and more right wing policies (Reagan and Thatcher). Workers would stay unemployed in the hope that good high paid manufacturing jobs would reappear.

Unions can also influence the NRU with protecting workers jobs and pushing up wages so that employers find it too costly to employ more labour. However the fall in the 1990’s could be due to the advent of technology in the hiring process and the growth of part-time jobs which assisted those workers facing a career change.

Another influence on the NRU is wage growth as with the higher wages you attract more of the labour force to engage in actively looking for work.

A central bank will have to use trial and error to make a decision on how much spare capacity there is in an economy. Only when prices start to increase do they have an idea how capacity is running.

Quality not Quantity

As alluded to by The Economist the goal of full employment must consider the quality of jobs as well. With the acceleration of technology over labour, maximum employment should consider more than capacity constraints or inflationary pressure.

Rather, governments need to consider the options available to workers: not just how easily they can find jobs they want, but also how readily they can refuse jobs they do not. By lifting obstacles to job changes and giving workers a social safety net that enables them to refuse the crummiest jobs, societies can foster employment that is not just full, but fulfilling.

Sources: The Economist 28th January 2017, St Louis Federal Reserve – Natural Rate of Unemployment

The ‘Output Gap” explained

I have being going over the theory behind the output gap and here is an explanation – written a few years ago. Probably not so applicable to the economic environment today

Just as Messrs Friedman and Phelps had predicted, the level of inflation associated with a given level of unemployment rose through the 1970s, and policymakers had to abandon the Phillips curve. Today there is a broad consensus that monetary policy should focus on holding down inflation. But this does not mean, as is often claimed, that central banks are “inflation nutters”, cruelly indifferent towards unemployment.

If there is no long-term trade-off, low inflation does not permanently choke growth. Moreover, by keeping inflation low and stable, a central bank, in effect, stabilises output and jobs. In the graph below the straight line represents the growth in output that the economy can sustain over the long run; the wavy line represents actual output. When the economy is producing below potential (ie, unemployment is above the NAIRU), at point A, inflation will fall until the “output gap” is eliminated. When output is above potential, at point B, inflation will rise for as long as demand is above capacity. If inflation is falling (point A), then a central bank will cut interest rates, helping to boost growth in output and jobs; when inflation is rising (point B), it will raise interest rates, dampening down growth. Thus if monetary policy focuses on keeping inflation low and stable, it will automatically help to stabilise employment and growth.

New Zealand’s NAIRU

Stephen Toplis at the BNZ produced an interesting graph showing the Non Accelerating Inflation Rate of Unemployment – NAIRU. With the increasing amount of structural unemployment in the New Zealand economy caused by a mismatch – Skills of unemployed v Skills required in the labour market – the NAIRU is around 5%. This means that an unemployment level of 6.7% is worringly tight and a level below 5% could be inflationary. This is likely to result in upward pressure on wages which will erode corporate profitability given that output growth will be constrained.

NZ Unemployment up but is it all bad?

Although the recent figures for the rate of unemployment in New Zealand have increased from 6.4% to 6.7% there are some interesting statistics with regards to participation rates and employment rates.

The employment rate increased 64.2% of the total working-age population, from 63.9%. The BNZ highlighted the following:

1. The unemployment rate hasn’t been affected too greatly during the last 4 years as NZ nears the bottom of the economic cycle;
2. NZ employment rate has settled well above that seen following the 1998 recession and significantly above that which was experienced following the early-1990s recession;
3. New Zealand’s early-1990s employment rate is about where a lot of the troubled developed-world economies now find themselves – Greece, Spain, and even the US. See graph below;
4. New Zealand, in contrast now has one of the highest employment rates in the world (testimony to its relatively high participation rate, coupled with a high rate of placement into jobs).

With firms indicating that it is their intention to take on more staff the BNZ estimate that the unemployment rate will be:

6.2% Dec 2012
5.6% Dec 2013

One wonders where the NAIRU is? The rate of unemployment when inflation is stable – maybe 4%. This is much lower than that of the US – see Beveridge Curve postings

Higher natural rate of unemployment will mean structural reforms

The recent special report in The Economist looked at the altering structure of the labour market worldwide. Obviously globalisation and technology have brought big changes in the nature of work, and levels of unemployment will remain high in the developed world as developing countries see their numbers employed being boosted.

Edmund Phelps, Nobel Economist, thinks that the US natural rate of unemployment in the medium term is realistically around 7.5% which is significantly higher than a few years ago. Remember the natural rate occurs when inflation is correctly anticipated – this level of unemployment results when the economy is at full employment.

Michael Spence, another Nobel prize-winning economist, agrees that technology is hitting jobs in America and other rich countries, but argues that globalisation is the more potent factor. Some 98% of the 27m net new jobs created in America between 1990 and 2008 were in the non-tradable sector of the economy, which remains relatively untouched by globalisation, and especially in government and health care. Lowering this natural rate will require the following:

1. changing education to ensure that people enter work equipped with the sort of skills required so that there is no mismatch
2. adjusting the tax system – incentivise work
3. modernising the welfare safety net – encourage those to find work
4. encourage entrepreneurship and innovation.

This is easier said than done.

Long-Term Unemployment
This has increased dramatically in many countries – 58% in Ireland, 40% in both Spain and Japan, and 30% in the US, see graph below.

The concern with these figures is that the longer poeple are out of work the less likely there are able to find future employment. There are two reasons for this:

1. Their skills get out-dated very quickly and this is especially prevalent in the current labour market as technology is starting to takeover many procedural white-collar jobs.
2. Motivationally they find it hard to engage in the process of lookign for work and this is esepecially prevalent once a person is on a generous welfare benefit.

According to The Economist:
Long-term unemployment often turns into permanent unemployment, so governments should aim to keep people in work, even if that sometimes means continuing to pay them benefits as they work.

New Zealand’s NAIRU and youth unemployment

The BNZ Economy Watch today talked of the labour market pressures that might be facing New Zealand over the next year – this is especially prevalent if the country is going to meet the needs of a more bouyant economy. What is interesting to notice is the actual unemployment figures during the recent recession compared with those from earlier downturns:

2010 – Unemployment 7%
1998 – Unemployment 7.9%
1991 – Unemployment 11.2%

This suggest that in 2010 the labour was already very tight going into the recession and had fallen to 3.4% which is well below what is considered New Zealand’s NAIRU (Non-Accelerating Inflation Rate of Unemployment) of 5.0% – earlier this year I did a post on the Austalian NAIRU – Aussies – cruising along nicely but watch for the NAIRU. So it could be said that the first stages of the recession were just reducing the excess demand in the labour market and even when in recession employers reported difficulties in finding skilled labour. See graph below

The BNZ is concerned that the labour supply is insufficient and has the potential to result in a combination of constrained economic expansion, rising unit labour costs and increasing inflationary pressures more generally.

Youth Unemployment
The current youth unemployment rate (those aged 15 to 19) is a staggering 27.5%. Moreover, the next age group up (ages 20 to 24) has an unemployment rate of 13.5%. See graph at the bottom of the post.

If the youth unemployed are the main pool of labour available to call on for economic growth then there may be issues in finding the necessary skills. At that point, however, the data becomes “curiouser and curiouser” when one looks even more closely at its composition. Despite the relative surge in the youth unemployment rate the proportion of unemployed who are youths actually falls. What this means is that youth employment fell and rather than unemployment rising folk simply left the labour force altogether. And boy did employment fall. Stephen Toplis BNZ

Inflation outlook
The labour market still appears to be very tight and this will ultimately lower New Zealand’s growth potential. This means that lower growth rates will impact on inflationary pressures as labour becomes more scarce and therefore this may lead to an increase in interest rates and the NZ$. Not really what New Zealand needs at this present time.

OCR stays at 2.5% but Bollard warns of hikes to come.

As on expectations the RBNZ held the OCR at 2.5% today. However Alan Bollard did suggest that tightening is anticipated in December but don’t be surprised if it is a 50 basis points increase as the bank is wary of inflationary expectations. The cash rate is expected to peak at 4.75% by the end of 2012 which means a further increase by 175 basis points.

According to the Bank of New Zealand the RBNZ’s inflation view are weighted to the upside. In particular, we note that “the Bank’s policy outlook relies on three key assumptions.
These are that:
– construction cost inflation will be subdued relative to its mid 2000s peak;
– households will continue to focus on reducing debt;
– recent increases in surveyed inflation expectations will be short lived”.

However, the labour market is also worthy of note. The Reserve Bank is forecasting the unemployment rate to fall to 4.5% which one would suspect is below or close to the non-accelerating inflation rate of unemployment – NAIRU. This could add inflationary pressures to the economy. According to Stephen Toplis of the BNZ:

Moreover, the RBNZ falls into the trap of assuming that the current 6.6% unemployment rate will act to suppress inflation near term. But this misses the point that the current youth (those aged 15 to 19) unemployment rate is 27.5%! The next age group is high too. The current unemployment rate of those aged 25 and over is just 4.6%. This is the group from which most skilled labour comes from. It is stretched already so we believe the risk of wage inflation is probably higher than the RBNZ expects.

Aussies – cruising along nicely but watch for the NAIRU

Although aggregate demand in the Australian economy is currently a little subdued the Reserve Bank of Australia seem to have plenty of ammunition available for stimulatory purposes. With the cash rate being 4.75% (see graph below) it could be said that the RBA are ahead of the play with regard to rate increases. The labour market appears to be strong and the terrible events in Japan will no doubt lead to a surge of commodity demand as rebulding and reconstruction proceeds. With this in mind there is the chance of capacity constraints and therefore investment in the mining and related industries will be essential. In the year the RBA will need to be aware of demand pressures as the economy puts its foot on the gas once again. With this expected growth and boost to employment figures the RBA will weary of the Australian NAIRU (see previous post – Australia’s NAIRU) and will want this unemployment figure to drop at a very slowly rate as inflationary issues could become prevalent. The Treasury estimate for the NAIRU (also know as the Full Employment range) is between 4.5% and 5% – see graph below.

So, while Wall Street became fixated by sub-prime mortgages and collateralised debt obligations, Australia concentrated on its natural endowments. Remember Australia never went through an official recession during the finanacial crisis.

Reserve Bank of Australia – Cash Rate


Unemployment and the NAIRU

NZ unemployment up to 6.8%

The pick-up in unemployment, which was above RBNZ expectations, should indicate that Alan Bollard will wait for a more robust rebound in the economy before tightening monetary policy. The indications are that he will wait till September before implementing contractionary measures. Commentators are optimistic in the long-run as, eventhough the unemployment figures are disappointing, some surveys are promising:

– business and consumer surveys are solid from 2010
– expectations about hiring in the labour market are positive

What is worrying is that wage and salary inflation is on the up, with unit labour costs running near 2% per annum, and nominal rates pushing 4%. Even with this level of unemployment one wonders what is the NAIRU – the non-acclerating inflation rate of unemployment. During the upturn economists looked at 5% being the rate at which unemployment didn’t impact on prices. These figures also suggests that we have some structural unemploymnet issues and a mismatch between vacant jobs and the skills of the unemployed.

Australia’s NAIRU

NAIRU – non-accelerating inflation rate of unemployment – is part of the CIE A2 course and below is a look at how it might affect the Australian economy and explanation of the theory.

While the US economy appears to be in danger of slipping into a double-dip recession and sovereign debt risks casts a shadow over Europe, the Australian economy powers on. The reason for this is the country’s biggest resources boom in more than a century. Perhaps the challenge of managing Australia’s economic success will turn out to be more difficult than steering the economy through the financial crisis. If economic growth picks up to 4% in the coming years, which is above the annual average rate, this will lead to serious capacity constraints and the economy would be heading towards full employment. With unemployment very close to 5% which Treasury estimates is Australia’s NAIRU – non-accelerating inflation rate of unemployment – a measure used to gauge when labour shortages start to feed into wage and inflation pressures. This would then threaten the RBA’s target band for inflation (2-3%) and lead to higher interest rates which would hurt those sectors of the economy that haven’t been a part of the commodity boom from China.

Explaining the NAIRU
Bill Phillips (of Phillips Curve fame) discovered a stable relationship between the rate of inflation (of wages, to be precise) and unemployment in Britain from the 1850’s to 1960’s. Higher inflation, it seemed, went with lower unemployment. To economists and policymakers this presented a tempting trade-off: lower unemployment could be bought at the price of a bit more inflation. However, Milton Friedman and Edmund Phelps (who both later picked up Nobel prizes, partly for this work), pointed out that the trade-off was only temporary. In his version, Friedman coined the idea of the “natural” rate of unemployment – the rate that the economy would come up with if left to itself. Now economists are likelier to refer to the NAIRU (non-accelerating inflation rate of unemployment), the rate at which inflation remains constant. The theory is explained below:

Suppose that at first unemployment is at the NAIRU, u* in the graph below, and inflation is at p0. Policymakers want to reduce unemployment, so they loosen monetary policy: that stimulates spending, so that unemployment goes down, to u1. Inflation rises to p1, along the initial short-run Phillips curve, PC1. But that raises inflationary expectations, so that workers demand higher wage increases and real wages rise again. Firms shed labour, returning unemployment to u*, but with a higher inflation rate, p1. The new short-run trade-off is worse, with higher inflation for any level of unemployment (PC2). In the long run the Phillips curve is vertical (LRPC).