Australia: Weighing the Work

The Australian economy is gradually opening up on the back of high vaccination rates. Nonetheless, the coronavirus remains a key risk to the economy, as the new coronavirus variant Omicron shows that the pandemic is far from over. At the time of writing, Australia had already reported a number of cases of Omicron. The Department of Health indicates that the new variant is manageable and that the pause in plans to reopen borders has been decided on an “abundance of caution”. However, much is still uncertain with regard to Omicron. The latest reports do suggest that Omicron is more transmissible than the Delta variant. This increases the odds of another disruption of the economy in case the symptoms are less mild than they currently appear, which is not yet clear at the time of writing.

Apart from the risk of the emergence of new variants, embarking on the road of economic recovery comes with other challenges. Supply chain bottlenecks are pushing up freight rates, inflation is at its highest level (see Figure 1) in over a decade, and businesses in certain sectors are scrambling for employees as skill shortages emerge. These developments are not unique to Australia; other regions such as the US and Europe are facing similar challenges. High inflation levels have fuelled discussions globally on central bank policies and the path towards policy normalisation and interest rate hikes. Some central banks have already raised interest rates (see Figure 2), while others, such as the US Federal Reserve, are on the cusp of accelerating the tapering of their asset purchases.

The Central Bank’s Conditions

In Australia, the RBA decided at its November meeting to discontinue the yield curve target of 0.1% for April 2024. This would allow them to raise interest rates before 2024. However, this decision was more or less forced by markets, as it only came after a historical surge in yields in the bond that it targets, leaving the RBA with little choice. If the RBA decided to maintain the target at 10bps, it would have ended up holding all freely tradable bonds. This, according to the RBA, would detract from the usefulness of the target. Since then, central bank governor, Lowe, has been firmly pushing back market expectations of the RBA increasing interest rates as early as mid-2022. The RBA holds on to the view that wages would have to increase significantly to sustain higher inflation levels in the longer term. This implies that developments in the labour market have taken centre stage in the RBA’s monetary policy going forward. And is underlined by governor Lowe’s latest speech on inflation, in which Lowe noted that: “at this juncture, the labour market is key”.

From that perspective, understanding the underlying dynamics in the Australian labour market is crucial. The tidal rise and fall of Covid-19-related restrictions and its impact on Australian business also has a disruptive effect on the Australian labour market. However, not all challenges currently facing the labour market can be attributed to the pandemic. Some features, such as low wage growth, have been a challenge for a prolonged period of time. This leaves us with a clouded view on the current state of the Australian labour market, which we hope to elucidate upon here.

This special report aims to disentangle the various aspects of the Australian labour market in the context of the pandemic. While doing so, we’ll take the reader along in our expectations with regard to unemployment, wage growth and the RBA’s monetary policy.

Historic labour market disruptions have tainted the past two years. Labour market disturbances are a direct result of the abrupt closure of service industry-related businesses like hotels and restaurants, of the sudden closure of Australian borders, and of the introduction of JobKeeper payments to maintain household income. So what is the current “unemployment” status in Australia?

In the wake of the initial phase of the pandemic, unemployment rose by more than 2 percentage points in Q2 2020. Since then, unemployment levels are steadily decreasing. They even dipped below pre-Covid levels recently, despite renewed lockdowns (see Figure 3). Furthermore, the number of vacancies is growing rapidly, pointing at increasing scarcity in the labour market. The perceived tightening of the labour market is sparking discussions on the state of economic recovery towards “full employment” and a potential policy normalisation by the RBA.

However, the unemployment rate may be misleading if one forgets to look “under the bonnet” of this labour market indicator.

Participation rates[1] have declined significantly and the underemployment rate[2] increased, even when unemployment levels remained relatively low (see Figure 3). According to our calculations, a 1 percentage point decrease in the participation rate is similar to a 1.1 percentage point increase in unemployment. This indicates hidden unemployment. Moreover, looking at the total number of hours worked, we observe a significant decrease in the number of hours worked over the past months (see Figure 4). The current number of working hours is still considerably (-2.8% ) below pre-Covid levels. Underemployment is still at 9%, which indicates that there are workers available who want to work more hours, but somehow aren’t sourced by employers. Both factors contribute to the view that there is still significant slack in the Australian labour market.

Nevertheless, we shouldn’t forget that Australia is just coming out of an extended period of severe lockdowns. From that perspective the current “starting point” for recovery is much better than last year. We expect that the Australian recovery can be as quick as last year’s and we expect that most workers will re-enter the labour market in the coming months. In the next section, we argue that such an expectation is realistic, albeit under certain conditions.

Is the Decline in Labour Force Participation Temporary?

To put some flesh to our reasoning, we take a closer look at the drivers behind the participation rates. Unlike in some other countries, such as the US, Australian labour force participation of older workers doesn’t seem to have declined as a result of pandemic-induced early retirement (see Figure 5). Participation rates have mainly declined in the younger age groups (20-24). This may be explained by the fact that younger people are more likely to work more in the service sector, like restaurants, bars and hotels, which were negatively impacted by the lockdowns. Furthermore, workers within this age group might have taken the opportunity to start a study or increase the time they spent on it. Hence, we expect these younger workers to return to the labour market when pandemic-related restrictions are lifted. This means that participation rates and hours worked should rebound in the coming months, approaching pre-Covid levels in the beginning of next year. Initially, this is likely to reduce pressure on the labour market as extra workers enter the job market. However, we expect them to be able to find jobs rather quickly. When this happens, the spare capacity in the labour market will be further reduced. Consequently, the labour market will become even tighter than before, possibly triggering higher wage growth.

[1]Participation rate = (labour force/adult civilian population)*100. In which labour force = (Employment + unemployment).

[2]Underemployment = Unemployed + employed who want to and are available to work more hours.

Scarcity on the labour market could spark wage claims, especially in times of elevated inflation, which in turn can lead to higher wage growth. There is a positive relation between wage growth and labour scarcity, represented by the ratio between vacancies and unemployed (see Figure 6). Logically, this means that an increase in the number of vacancies or a decrease in the unemployment rate positively correlates with wage growth. With the Australian economic recovery ahead, we can reasonably expect this ratio to increase further, raising expectations for higher wage growth through 2022. But are these assumptions on increased employment rightfully made? What patterns emerge if we look at recruitment and wage growth in more detail?

Headlines depict a picture of employers scrambling for employees. Especially in sectors initially affected by the pandemic, such as accommodation and food services. By looking at these trends more closely, we can confirm that recruitment activity indeed increased during last year’s economic rebound (see Figure 7). The net increase in employment was also positive from October 2020, before dipping into negative territory during the second wave in winter 2021. Moreover, recruiting activity has again been on the ascend since last month, showing the first signs of another rebound.

Moreover, this trend is likely to continue, as employers expect to increase their workforce in the coming three months (see Figure 8). Accommodation and food services are leading the way, with almost 50% of employers expecting to increase staffing levels. In the longer term, we distinguish a similar dynamic (see Figure 9). Most industries, although not all, expect employment growth between now and November 2025. These expectations bode well for employment and could be an indicator of a prospective decline in unemployment, resulting in an even more favourable – for employees– unemployment versus vacancy ratio. This would strengthen the bargaining position of new and existing employees and could in turn lead to higher wages and wage growth in the coming period. Are employees already reaping benefits from these developments?

What Is the Effect on Wages?

The latest data release on wage growth partly reflect this labour market scarcity through a 0.44 percentage point increase in wages. This brings wage growth in the private sector to 2.3%, while public sector wage growth lags behind at 1.7%. Wage growth is relatively broad-based (see Figure 10). There are some sectors outperforming with regard to wage growth, such as professional scientific and technical services, administrative and support services, rental hiring and real estate, and arts and recreation. But most of the sectors that have relatively high wage growth started from a relatively low base.

Overall, these developments look promising at first glance, but wage growth is still somewhat subdued when compared to the pre-pandemic averages (see Figure 11). Current wage growth in all but three sectors is lower than the average wage growth of the decade preceding the pandemic. Not to mention the fact that low wage growth was already an issue before the pandemic struck. This means that wages not only have to increase in order to be “on par” with pre-pandemic levels, they also have to significantly surpass them to get close to the wage growth that the central bank requires to change its policy settings. This feels like starting a game 0-1 down.

Moreover, we shouldn’t forget that the past two years have been very unique in the history of the Australian labour market. In the last few years, the Australian labour market has operated in complete isolation, whereas it normally benefits from foreign workers and working holiday makers. What could be the effect on wage growth when Australian borders open up to foreign workers?

Australian borders were closed on 19 March 2020 as part of the Australian government’s strategy to control Covid-19 cases. The strategy worked relatively well, as the number of cases has remained among the lowest globally. However, closing the borders came with collateral damage. The tourism sector took a large blow, universities missed out on international students and businesses that rely on foreign workers in the form of immigrants or paid holiday workers were suddenly forced to draw employees from a different pool of potential workers. This shortage of foreign workers may contribute to increasing labour scarcity and thus increase the likelihood of higher wage growth.

Indeed, when we take a closer look at the effect of net immigration, job growth and wage growth, we find a positive correlation during the pre-Covid period (see Figure 12). This implies that more immigrants (corrected for new jobs) limit higher wage growth. Looking back over the past two years, this means that wage growth probably benefited from the lack of immigrants. Furthermore, the return of students and working holiday makers collapsed with the closure of the borders (see Figure 13). Consequently, the return of these potential workers will also add to the labour pool. Looking ahead, we can expect the number of net immigrants in the form of students and working holiday makers to increase when border restrictions are lifted. This will increase labour supply and reduce labour shortages, which in turn lower expectations of wage growth.

So when can we expect this process to start? Initially, borders were to reopen to non-Australian residents and visa holders from December onwards, but due to the emergence of the Omicron variant, this date has already been pushed back to 15 December. As it currently stands, borders will open to eligible visa holders including skilled and student cohorts, as well as humanitarian, working holiday makers and provisional family visa holders. In addition, fully vaccinated Japanese and Korean citizens can visit Australia quarantine-free, as well as residents from Singapore. Putting major setbacks aside, most restrictions are likely to be lifted by Q2 next year. This means that a potentially tight labour market as a result of the post-pandemic recovery could be eased by international workers from mid-2022 onwards. This will delay the expected tightening of the labour market and provide a backlash for significant wage growth.

International Competition

Besides labour-related factors, there are other externalities that can negatively influence the bargaining position of workers and wage growth. One of these factors is international competition. According to the central bank: “The laser-like focus on cost control in Australian business over the past decade has made firms wary of increasing wages.” In the past, this cost focus incentivised companies to try and control costs they can control, i.e. labour costs, and they are not expected to increase wages for that same reason going forward. On the other hand, Australia currently enjoys a relatively favourable competitive position as the current Terms of Trade Index[3] is at a record high (see Figure 14). The current high levels of this index can partly be explained by the high demand for iron ore, gas, and coal in the first half of 2021, as a result of the global rebound after the pandemic. Nonetheless, it is questionable how sustainable these high levels are. Input costs are increasing as a result of supply chain bottlenecks and iron ore prices are far below their recent highs. It is easy to imagine companies continuing to suppress wages to keep costs manageable going forward.

[3] The index measures the relative prices of the country’s imports and exports. A high index means that the prices of export goods/services are relatively high compared to the prices of import goods/services. A comprehensive definition can be found here.

However, will employees actually accept this low wage growth from their employers? Perhaps employers use other levers to satisfy wage demands by their employees, for example bonuses. It seems like the wage growth including bonuses has been accelerating at a higher pace than without bonuses since 2017 (see Figure 15). However, we cannot visually confirm this relation looking at the past quarters, as wage growth with and without bonuses accelerated at a similar pace.

Furthermore, the pandemic could trigger structural shifts in employment across sectors. Regarding office jobs, we have proved that employees can work entirely from home, so why not relocate some of these jobs to low-wage countries? And as for blue-collar jobs, why shouldn’t companies invest more in automation to hedge the “operational risk” of employees not being able to come to the factory? Such shifts will only accelerate in case of a tighter labour market and higher wages. At this point in time it’s too early to determine the impact of these developments, but it is plausible that the pandemic will act as a catalyst for some of these trends. These factors may further erode the bargaining position of Australian workers, resulting in continued subdued wage growth.

Many developments are at play in the Australian labour market: Covid-19-related complexities, domestic dynamics, and considerations with regard to international competition. Nonetheless, by dissecting the various components, we get a clearer grasp of the situation and the future prospects (see Table 1). While circumstances look bright and colourful at first sight, a closer examination reveals a gloomier picture. This has implications for our expectations with regard to monetary policy.

As we know, the RBA has been very hesitant to raise rates before materially higher wages have been achieved. According to Governor Low noted in the last statement on the monetary policy decision:

“The Board will not increase the cash rate until actual inflation is sustainably within the 2% to 3% target range. This will require the labour market to be tight enough to generate wages growth that is materially higher than it is currently. This is likely to take some time and the Board is prepared to be patient.”

We do expect key indicators of labour and wage growth to improve on the back of Australia’s economic recovery. However, we do not expect these improvements to elevate wage growth significantly above the pre-pandemic trend, at least not in the short term. Since the RBA is so clear about wanting to see wage growth before thinking about interest rate hikes, we do not expect the RBA to raise rates for at least another year. “Patience is a virtue”.