Moderate wages growth misleading

ABS data for the September quarter that indicates a moderation in wages growth is misleading, warns economic forecaster BIS Shrapnel. The timing of this year's review of Federal Award minimum rates is responsible for much of the easing.

"A closer analysis of the latest wage data clearly shows the slowdown concentrated at the low skilled end where award minimums are more relevant. Other aspects of the data continue to show wages growth still running at a touch over 4%," said BIS Shrapnel Chief Economist Frank Gelber.

"The extent of wage pressures is of critical importance right now."

"Our fear is that the whole situation facing monetary policy is about to change dramatically - namely, that rising wages growth and a more sustained wage-driven rise in inflation are starting to force the Reserve Bank's hand," Mr Gelber said.

BIS Shrapnel believes the Reserve Bank faces a tougher task in containing inflation in the year ahead than many commentators expect. Though the three interest rate rises in 2006 will dampen demand, Mr Gelber warns it may not be enough to see off the current rise in inflation.

"The latest interest rate rise has taken mortgage interest rates over 8% - likely to be a trigger-point for many borrowers. We expect this latest rise will start to have a cooling effect on housing markets and consumer demand in the months ahead. With the drought and easing oil prices also impacting, there may be enough dampening influences to take the pressure off inflation," said Mr Gelber.

However, BIS Shrapnel believes households will again prove resilient in the face of interest rate rises.

"Our estimates suggest the cash flow effects of higher debt servicing costs will be largely offset by the boost to incomes from surging employment, rising wages and tax cuts. This increases the likelihood the RBA will have to raise interest rates again, and by more than just another quarter of a per cent."

"And with Australia's labour markets tighter than they have been in over 30 years, profits riding high and businesses in the midst of a major expansion in capacity, the threat of a rise in wages growth is very real," he said.

If wages growth starts to push up towards 4.5% or higher, BIS Shrapnel believes there is a risk the economy will experience a stronger, more persistent period of inflation. In this instance, the RBA would have little option but to tighten monetary policy until demand cooled sufficiently to weaken labour demand and bring wages growth back into line.

"This could be hard to achieve," said Mr Gelber.

"In particular, the RBA could find itself in a difficult situation where it needs more significant interest rate rises to rein in booming business investment - now the key driver of growth and rising employment, and a less interest rate sensitive part of the economy."

"On balance, we think there will be enough pressure for the Reserve Bank to raise interest rates by another quarter per cent over the first half of 2007. But the big risk remains that rates may need to go higher still."

The problems the Australian economy is currently experiencing are being compounded by a slowdown in productivity, according to BIS Shrapnel. After averaging annual productivity growth of 2.5% through much of the 1990s, the economy has averaged 1.5% growth so far this decade and is struggling to post any at all at the moment.

"The productivity purple patch the economy hit in the mid to late 1990s was clearly a one-off phenomenon. The economy has entered into a more subdued period of productivity growth that means producers are finding it harder to contain costs."

"The problem of high inflation will not go away quickly. The RBA will retain its tightening bias as long as labour constraints generate demand-inflationary pressure. The key question will continue to be how many rate rises will be required before this episode is over," concluded Mr Gelber.

Reprinted with permission. The Australian Property Review. http://www.apr.com.au