Persistent excess demand vs returning inflation to target

The RBA’s economic outlook points to persistent excess demand, which jars with its expectation that inflation returns to target over the next few years. If the RBA pulls off a soft landing, the contradiction might end up resolved by inflation staying above target for longer, such that the RBA overachieves on the employment half of its mandate.

The RBA has become more transparent over the past few years and is now publishing estimates of spare capacity in the economy, as measured by the output gap, the gap between the unemployment rate and the NAIRU, and the gap between the hours-based underutilisation rate and its respective NAIRU.(1)

These measures of slack are reported as ranges because potential output and the two NAIRUs are unobservable and are estimated using a variety of techniques.

Taking the midpoints of the RBA ranges, the RBA estimates suggest that there is still excess demand across the board, albeit less than the stimulus-driven extremes reached when the economy rapidly recovered from the short-lived, but very deep COVID-driven recession in 2020.

That is, GDP was about 0.9% above potential in Q1, down from a post-COVID peak of 2¼%, while the unemployment rate was around 0.7pp below the NAIRU in Q2, narrower than a 1.1pp gap when the economy was recovering, and the underutilisation rate was about 1.2pp below its respective NAIRU in Q2, less than a 1.7pp difference during the economic rebound.

To judge what might happen to spare capacity over the next few years, we forecast the three gaps using RBA estimates for GDP, unemployment and underutilisation, assuming that potential GDP continues to grow at its most recent annual rate and that the NAIRU and underutilisation NAIRU hold steady over the forecast horizon.

On this basis, excess demand is actually expected to persist, with output averaging around ½-¾% above potential, the unemployment rate holding about 0.4pp below the NAIRU, and the underutilisation rate about 0.6pp below its NAIRU, all calculated using midpoint estimates for potential output and the two NAIRUs.

The gaps persist because the RBA is forecasting GDP growth to pick up to about 2½%, marginally above the latest estimate of potential growth, the unemployment rate to peak at 4.4%, below the current NAIRU of about 4¾%, and the underutilisation rate to peak at 5.8%, below the respective NAIRU of almost 6½%.

Given that the RBA expects underlying inflation will broadly return to the 2½% target by 2026, the seeming disconnect between the activity and labour market forecasts pointing to persistent excess demand suggests that judgment has been applied to the inflation profile.

Every forecaster needs to apply judgment at times and in this case it probably reflects a combination of factors, namely:

• The RBA might believe that potential GDP and the two NAIRUs are better represented by the figures implied by the extremes of the historic gaps, namely 2½% potential growth, a 4¼% NAIRU, and a 5¾% underutilisation-based NAIRU, rather than the midpoints;
• The RBA could be worried that the economy will underperform its outlook over the next few years; and
• Every inflation model is imprecise and can have large forecast errors at times.
  

On the first point, the governor said in June that she thought the NAIRU was 4.3%, below the 4¾% midpoint, which suggests she would expect the unemployment gap to be broadly closed based on the staff’s current outlook.

On the second point, the RBA might be right to be worried that the economy could underperform given that it – like the market – regularly has large forecast misses for both activity and the labour market, where its concern could be magnified if the US finally enters recession.

That said, the Beveridge curve is yet to normalise in Australia, suggesting that further weakness in the demand for labour could be mostly absorbed by job vacancies returning to pre-COVID levels rather than a sharp rise in unemployment, while it is worth acknowledging that the RBA has a better track record than the Fed in engineering soft landings.

However, if a soft landing is realised, the seeming contradiction between the implied outlook for persistent excess demand and the forecast achievement of the inflation target might end up resolved by inflation staying above the target for longer, such that the RBA might overachieve on the employment half of its dual mandate.

Note:
(1) The hours-based underutilisation rate captures the hours of work desired by current and unemployed workers.