This week the latest inflation figures will be examined closely to see if, for the first time since 2008, we are about to have a break-out of inflation.
But not only do the lockdowns and emergence from the pandemic complicate matters, history would suggest we need unemployment to fall further than it is now before we need to worry about inflation.
Last Friday, while speaking at an international conference, the governor of the Reserve Bank mentioned the non-accelerating inflation rate of unemployment (Nairu).
The term refers to a pretty dry but contested bit of economic theory that is more commonly known as either “full employment” or “natural unemployment” (although even that is contested).
Given in reality you can never get to 0% unemployment, natural unemployment is suggested as being the point you can’t go below without labour constraints causing rising wages that in turn force up prices.
No one knows precisely what the Nairu is at any point in time. We can only estimate – and if you work for the RBA you will develop up a pretty complex mathematical formula to do so.
The RBA estimates that back in the 1980s it was probably about 6%, in the 1990s it rose to as high as 7%, by 2010 it was about 5.5%, and now it is somewhere about 5%.
The reason it moves around is the economy is not static.
When the Reserve Bank adopted its inflation target of 2%-3% of underlying or core inflation after the 1990s recession it seemed pretty clear that so long as the unemployment rate was above 5%, inflation would remain stable.
But once unemployment went below 4.5% in 2007 and 2008 inflation spiked:
But since the GFC, inflation has not so much accelerated, as decelerated and has been as often below 2% as above it:
So what is the Nairu now?
Philip Lowe told his audience on Friday that the RBA does “not have a numerical target and I don’t think it makes sense to do so”.
He suggested that “experience has taught us that the non-accelerating inflation rate of unemployment moves over time and is influenced by many factors outside the control of the central bank”.
He certainly is right there.
One of the main reasons the Nairu moves around and has fallen over the past 20 years is that the level of unemployment that in the past saw wages growing about 3% is much higher than it is now:
It also means that we very rarely reach a level of unemployment where inflation takes off. In the past 30 years it only happened once during the mining boom:
So why should we care about it now?
Mostly because with inflation expected to spike due to the pandemic there is going to be a lot of talk about capacity constraints because unemployment is at 4.6% and thus interest rates need to rise to prevent inflation taking hold.
And yet what we have seen over the past decade is not just that inflation has been weak, but that unemployment has become less important at explaining the strength of the labour force.
The main reason has been the increase in underemployment since the GFC:
The growth of part-time employment has led to more employed people chasing more hours than in the past.
One other aspect has been the growth of long-term unemployed.
At the moment, 29.3% of everyone who is unemployed has been so for more than a year – that is more than double the ratio of long-term unemployed that occurred back in 2008 when the unemployment rate was last below 4.7%:
On Wednesday the headline CPI inflation number is likely to grow again at a level that would usually be associated with an overheating economy.
But clearly there is a lot of capacity left in the labour market.
In the past, unemployment has needed to go below 4.5% before we have seen a strong increase in underlying inflation. We are around that level now, but the figure makes little sense and explains less of the economy than it once did – especially with high underemployment and long-term unemployment.
In time the economy will grow such that interest rates will need to rise to cool things down. But for now we see an economy affected more by lockdowns and closed borders than exuberance, and those calling for interest rates to rise should hold off.
Greg Jericho writes on economics for Guardian Australia