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Looking beyond Australia's inflation obsession
Labour market data are currently playing second fiddle in Australia where the macroeconomic news is all about inflation, inflation, inflation and what that means for interest rates. But the labour market contributes to the macroeconomic picture in three important ways.
First, employment and wages feed into household incomes that drive consumer spending, which makes up around half of aggregate demand in the economy. Second, labour market trends shape inflation through wage dynamics and cost pressures. And finally, full employment is part of the central bank's dual mandate, and so, explicitly feeds into monetary policy considerations, albeit in second place to inflation.
Data this week showed Australia's labour market remains historically tight, with the unemployment rate remaining at 4.1% in January, up from its lowpoint of 3.4% in 2022 but still well below its pre-pandemic level of 5%. A "tight" labour market would typically be associated with a robust economy and strong growth in labour demand. But the data instead shows employment growth has slowed to just 1.0% in January, down from 3.0% a year earlier.
Rather than being driven by strong labour demand, the ongoing tightness of the labour market over the last year reflects slower growth of labour supply. There has been some easing in population growth as net overseas migration normalises. But the main reason for the slowing in labour supply is that fewer working-age people are choosing to participate in the workforce, possibly because the easing in cost-of-living pressures over 2025 allowed some people to scale back their work effort. Had workforce participation been unchanged over the last year, then the unemployment rate would currently be 4.9% and the discussion would no longer be about labour market tightness. With cost-of-living pressures back in the fore, this downtrend in labour force participation has likely run its course. Any rise in the participation rate, when combined with continued soft employment growth, should see the unemployment rate edge gradually higher from here, bringing the labour market closer to balance.
Wage data showed the annual growth in the wage price index (WPI) remained broadly steady at 3.4% in the December quarter. Private sector wages, which are typically a better guide to labour market tightness, are relatively stable at 3.4% while public sector wages accelerated to 4.0% as frontline health care workers across NSW received wage gains. The ABS report that federal government funded initiatives across aged care and childcare lifted wages in both the private and public sector. But is wage growth of this magnitude really reflecting a “tight” labour market?
The answer is - not really. In a balanced labour market, defined as being consistent with inflation being at target, we would expect nominal wage growth to be running at the rate of target inflation (2.5%) plus productivity i.e. real wages growing in line with productivity. While labour productivity fell precipitously in 2023 and 2024, it has since lifted to be running at 0.8% in the September quarter. This means that wage growth of 3.3% would be expected in a balanced labour market, given current productivity. This is similar to the 3.4% growth in the WPI, suggesting a labour market in balance rather than tight.
But broader measures of wage inflation, such as average earnings in the national accounts (AENA), are currently growing more rapidly, and better reflect underlying conditions in the labour market. Wage growth measured by AENA includes bonuses, promotions, superannuation contributions and compositional changes in the labour market that are not covered by the WPI. AENA is currently running at an annual rate of 5½%, around 2 percentage points faster than the WPI, and at a rate that is clearly inconsistent with the central bank achieving its inflation target with current productivity growth. It is unsurprising then that inflation is currently above target. As the labour market moves back towards better balance, AENA wage growth is likely to converge towards WPI growth.
What other insights can we glean from the labour market for the macroeconomic outlook?
Firstly, for households, slower growth in employment combined with steady wage growth implies slower growth in labour incomes. News headlines that have focussed on falling real wages are technically correct, as wage growth at 3.4% on the WPI is below inflation of 3.6%. But given the strength of wage costs outside the scope of the WPI, these headlines likely overstate the impact on households, and the outlook is far less dire. Disposable income growth will slow over 2026 as labour income growth eases and the rise in interest rates lifts mortgage repayments. This will be partly offset by modest tax cuts that come into effect in July and the benefit of higher interest rates to households who are net savers. We expect real disposable income growth to slow from around 5% currently to 1½% over the year ahead, a slowing but not a collapse like in 2022-23 when it contracted by 4% a year. Ongoing modest growth in real disposable incomes provide a solid foundation for consumers to continue to spend, though at a less exuberant pace than that witnessed during the sales periods pre-Christmas.
Secondly, the trajectory for a gradual easing in costs and inflation remains intact. The economy is rebalancing away from public-led to private-sector-led growth. GDP growth is expected to be around trend and the rebalancing should see a modest rise in productivity growth to around 1.0%. With productivity recovering and AENA wage growth converging toward WPI, the inflation impulse from unit labour costs should gradually fade.
Finally, for the RBA, their assessment that the labour market is currently a little bit tighter than full employment remains unchanged, consistent with inflationary pressures currently being above target and their recent hike in interest rates. Moving forward, an easing in labour market pressures will be key to ensuring the central bank does not have to implement a more protracted hiking cycle.