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Economic and Financial Market Update: Short Term V Long Term

21 May 2021

Summary:

Many firms are saying that conditions are very buoyant;
But while demand is strong, there are a number of supply side constraints;
The risk is that the supply-side constraints last longer than what financial markets and central banks think;
Wages growth although low is rising, and may increase further as the jobs market stays strong.

The economy is powering ahead. Firms indicated that conditions in April were at their strongest level in at least 25 years. The Budget was designed to give the economy another big shove. The health efforts to fight the virus have played an important role in boosting the economy. But they also act to restrict supply.

The key question for central banks (such as the RBA) and financial markets is how much of this mismatch between supply and demand is short term and how much is long term. There is a clear risk that some supply shortages could last for an extended period. Most notably labour shortages may remain part of the landscape, at least until the international border re-opens.

One of the key indicators that the RBA will be watching to understand whether the rise of inflation is short- or a long-term phenomenon is wages growth. In both the December and March quarters’ wages growth was surprisingly strong. The big picture is that there has been a dramatic fall in the underutilization rate (unemployment rate plus those working part-time that want a full-time job). And this usually coincides with stronger wages growth.

Conceptually it would be expected that the heightened labour shortages would lead to firms offering higher wages (there are anecdotes this is happening). Rising labour shortages did not lead to higher wages growth pre-COVID. But they could this time. The participation rate is already near record highs (of course it could always go higher). And the Centre for Population does not expect immigration growth to return back to its pre-COVID levels until at least mid-2024.

The other key factor to watch as to whether any price rise is sustainable is inflation expectations. Certainly there has been a rise in companies’ views about prices. To date the rise of consumer inflation expectations has been more muted. Medium-term financial market inflation expectations have risen back towards the RBA’s 2-3% inflation target. The RBA expects ‘underlying’ inflation to only be 2% by mid-2023.

Sustained low inflation may well be the right call. But the data is likely to show higher prices for at least the next couple of quarters. The longer that there are labour and supply shortages the more likely there will be higher prices and workers will demand higher wages.