The RBA is based on an outdated theory about inflation and employment

My economics teacher at Randwick Boys High was either well read or way ahead of his time.

But back in 1974, Mr. Geddes made an amazing statement in class one day.

There was a growing school of thought, he told us, that from now on full employment means that about 5 percent of the workforce will be out of a job.

Five percent! That seemed like a pretty big part of the workforce, given that unemployment had averaged just 2% for more than 20 years. And a convenient and beautiful round number. It was almost as if it had just been invented.

While he explained that as the economy evolves, more people will change jobs and be temporarily laid off, he did not mention the perverse thinking behind this new impulse; that it was somehow desirable to have a large pool of idle workers. More on that later.

It’s a theory that has taken hold in the world of economics, despite growing doubts about how it works.

While it will play a key role in the Bank of Australia’s decision to keep interest rates on hold, it will barely rate a mention in the accompanying RBA statement.

In short, the RBA would like more Australians to lose their jobs.

Gov. Michele Bullock would never be as blunt as that, of course. And to her credit, she rejected calls from a legion of vocal senior economists to raise interest rates, to deliberately trash more workers.

Many still firmly hold the view that if you want to kill inflation you need 5% of workers to sit on their hands and are annoyed that the RBA has not listened to their calls for ever higher rates.

Instead, the RBA targeted a top-line unemployment rate of 4.3%.

When last week’s figures for August came in unchanged at 4.2%, the disappointment was palpable.

Any chance of an imminent rate cut has been ruled out, for now.

Blame Bill Phillips

In June, this little gem of central bank doublespeak was included in the governor’s decision on why interest rates were kept on hold.

“Labor market conditions have eased further over the past month but remain tighter than is consistent with sustained full employment and inflation on target.”

Here’s a simple English translation: “More people have lost their jobs in the past month, but not enough to ensure we have full employment and keep inflation under control.”

That is correct. We need more people out of work to make sure we have full employment.

The theory behind all this comes from New Zealand and a famous economist named Bill Phillips.

He came up with the idea, which he unsurprisingly called the Phillips Curve, that there is an inverse relationship between the labor market and inflation.

If unemployment is low, inflation is likely to be high because firms must pay higher wages to attract decent workers.

And when unemployment is high, inflation goes down because fewer people can afford to buy things.

The mid-1970s, when his theory really gained ground, was a time of great turmoil.

Global oil price shocks, after the OPEC cartel decided it was not getting a decent return on its product, have rocked the economies of developed countries, sending the US and Britain into recession.

Australia may have avoided recession, but inflation exceeded 15% and unemployment, which had averaged just 2% for the previous 15 years, suddenly began to rise.

As the cost of living rose, industrial stocks exploded. Strikes became a daily occurrence and relations between employers and unions became increasingly toxic.

The arrival of the Hawke-Keating governments in 1983 and the implementation of a series of agreements finally took the heat out of the situation.

Never mind the evidence

One thing that went largely unnoticed during this period was that the Phillips curve did not work.

Inflation and unemployment together have been in orbit for more than a decade and a half.

From 15.4% in 1974, inflation ended the 1980s at 7.3%. Unemployment rose from about 2.5% to nearly 10% during the same period, before falling to 6% in the late 1980s. It quickly returned to 10% in the 1990s recession.

Despite this lack of correlation, economists stuck with the theory. For central banks, including the RBA, it has become an article of faith; if you want to control inflation, you have to sacrifice workers.

It is still deeply rooted in their thinking.

To avoid openly discussing this, they came up with a code. It’s called the NAIRU, the non-accelerating inflation rate of unemployment. This is the unemployment rate that will keep inflation within the target range of 2-3%.

It’s a deliberately odd-sounding acronym, cleverly designed to avoid the obvious embarrassment of suggesting that large numbers of Australians should be sacrificed for the greater good.

Amazingly, no one can actually tell you what the NAIRU is. That’s because I just don’t know. For years, whenever the unemployment rate dipped below 5%, the red lights would start flashing.

The RBA suggests 4.3% unemployment based on its forecast. But in the years leading up to the pandemic, it became precarious as inflation fell to dangerously low levels, even as jobs numbers were incredibly strong. Again, the theory just didn’t hold.

Former Treasurer Josh Frydenberg admitted in 2021 that the NAIRU estimates were wrong and the Treasury was forced to cut it.

“As foreshadowed, they now estimate the NAIRU to be between 4.5 and 5%, down from their previous estimate of 5%,” he said.

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Who beat inflation?

There is no doubt that the RBA, along with other major central banks, did a great job of keeping inflation under control once they gained independence from government in the 1990s.

But they were not alone in the fight. In fact, you may have simply ridden the outgoing wave.

Globalization and the rise of China have effectively driven down the price of consumer goods, electronics, heavy machinery, ships and automobiles year after year. In essence, China was exporting lower inflation and higher unemployment, especially to major industrial countries such as the US.

But there was another big change, particularly in Australia.

The Phillips curve assumes that workers can simply demand more money when unemployment is low. They can to an extent. But workers are nowhere near as strong as they once were.

In Australia, you have to ask the courts for permission to take wrongdoing. As a result, the number of industrial disputes has declined since the 1970s.

That destroys a key piece of Bill Phillips’ theory and thinking at the RBA’s Martin Place headquarters.

Look at what happened in the last two years. Wage increases over the past two years have not covered rising prices, resulting in a loss of real income for households.

This greatly affected economic growth as household consumption fell.

Inflation is falling. So clearly, by definition, the current level of unemployment is already helping to reduce inflation.

Month after month, RBA missives worry that “inflationary expectations could become entrenched” without considering that workers have little power to do anything about it.

Maybe it’s time to throw Bill Phillips’ theory in the trash.