Christopher Kent: Cyclical and structural changes in the labour market
Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of
Australia, to the Wall Street Journal's Labour Market Developments gathering, Sydney,
16 June 2014.
* * *
I thank David Jacobs, Kim Edwards, Daniel De Voss, Sharon Lai and Josef Manalo for help in preparing these
remarks.
I appreciate the opportunity to talk to you today about some key cyclical and structural forces
affecting the Australian labour market over recent years. Not surprisingly, we spend
considerable time and effort at the Bank trying to understand labour market developments
given their relevance to both unemployment and inflation.
Developments over the past couple of years
Over recent months, labour market conditions have shown some signs of improvement.
Following only very modest growth last year, employment has grown by almost 0.9 per cent
so far this year. The unemployment rate ticked down a few months ago and the participation
rate appears to have stabilised somewhat, after a significant decline through 2013. These
improvements appear consistent with some signs of better growth in economic activity,
although I'll come back to this point in a few minutes.1
Despite these improvements, there is still a fair degree of spare capacity in the labour
market. This is apparent across a number of dimensions (Graph 1):
• the unemployment rate is high relative to its recent history
• the participation rate is around the lowest it's been over the past eight years
• there's been a significant decline in the ratio of employment to the working-age
population since 2010
• wage growth has declined, to be well below its average of the past decade.
Graph 1
My plan today is to discuss some of the key forces at play that have led the labour market to
this point, and think about prospects for the future.
Demand and supply: what's driving labour market developments?
Like all markets, developments in the labour market reflect the interplay of demand and
supply. These determine outcomes in terms of quantities (such as employment) and prices
(namely wages). There are three key developments that help to explain the dynamics over
the past few years:
• First, over that period there has been a weakening in the growth of labour demand,
reflecting the decline in mining investment and the still weak state of overall demand
across the non-mining economy.
• Second, there's been a decline in the growth of labour supply, some of which
reflects a cyclical "discouraged worker" effect, but the ageing of the population is
also a significant and enduring influence.
• Third, wages are adjusting to the degree of spare capacity in the labour market.
Moreover, slower growth of wages is playing a part in the real exchange rate
adjustment that is required as the terms of trade and mining investment decline.
To a large extent, these developments reflect an unwinding of some of the adjustment that
was seen over the period when commodity prices were rising and the mining boom was in
the midst of its investment phase. As my colleagues and I have noted elsewhere, that period
saw a significant appreciation of the nominal and real exchange rates, alongside relatively
strong growth in both employment and wages - particularly for mining and mining-related
activities.2 These changes are now working in reverse, with the nominal exchange rate and
growth of wages lower than they had been. Both are helpful parts of the necessary
adjustment process. Monetary policy is also playing its role by providing support to demand.
Labour demand: the transition away from mining-led growth
In large part, subdued growth of labour demand over the past couple of years has reflected
below-trend growth in output over much of that period. The economy has been facing various
headwinds over that time, including: the decline in the terms of trade; the decline in mining
investment; the high level of the exchange rate; and weak growth of public demand.
The demand for labour can be thought of as being derived from the demand for the goods
and services it helps to produce. So it is not surprising that employment growth weakened
and the unemployment rate turned up from around the middle of 2012. That corresponded to
a noticeable slowing in the growth of economic activity, which remained relatively subdued,
at least up until late 2013 (Graph 2). In turn, much of that owes to the decline in mining
investment. Meanwhile, growth of activity in the non-mining economy was subdued through
that period, but it picked up slightly from late last year. That modest pick-up may have
contributed, at least in part, to improved employment growth over the past few months. It
may also be that some of that improvement reflects a "catching-up" of employment growth
after only very modest growth through 2013.
Graph 2
GDP growth lifted noticeably around the turn of this year - and was running at a bit above
trend over the year to the March quarter 2014. But much of that owed to a very strong
contribution from the production and export of resources, which does not draw on much
labour. The strength of resource production of late partly reflects an improvement in labour
productivity in the mining sector, which is to be expected as new productive capacity comes
on line.
However, measured labour productivity growth has improved over the past few years across
a broader range of industries, following a period of quite weak growth (Graph 3). If this can
be sustained, it would be a very positive development, including for employees who will in
time benefit through sustainable gains in their earnings. Over the past couple of years, it has
meant that the growth in output that we've seen has been achieved with relatively moderate
growth in employment. Outside of the mining sector, the general improvement in productivity
growth may have been in response to a range of competitive pressures coming to bear
during a period of weak growth of aggregate demand. The still high level of the exchange
rate is one such competitive pressure.
Graph 3
The transition from the relatively labour-intensive investment phase of the mining boom to its
capital-intensive production phase is apparent in employment growth across different
industries. Stepping back for a minute to the period from 2008/09 to 2011/12 (just prior to
what appears to have been the peak in mining investment), resource-related activity
accounted for a bit more than half of the growth in employment (Graph 4).3 Much of that was
in the mining industry itself, but much was also in industries that provide inputs to resources
extraction or investment. Business services, manufacturing and construction all benefitted
directly from this resource-related activity.
Graph 4
Now, as we are starting to see the decline in mining investment, there has been a reversal of
some of these earlier trends. Most notably, business services employment has declined
significantly, with firms more exposed to the mining sector particularly affected (Graph 5).
Also, mining employment has plateaued since about mid-2012. Meanwhile, there has been
further strong growth in employment in household services, which has accounted for a
significant share of the growth in employment over recent years. There's also been a slight
upward trend in employment in construction, consistent with the prospect of a strong pick-up
in both residential and non-residential building, which will require more workers in this sector
in the period ahead.
Graph 5
The relatively weak state of overall labour demand over the past couple of years has been
evident in measures of employment intentions, job vacancies and advertisements. Some of
these have shown signs of improvement of late, but they remain at relatively low levels.
Households' expectations have adjusted as well; weak growth of labour demand has
translated into concerns over job security. In turn, concerns over job security and labour
market conditions have led to a decline in the rate of employee resignations which, in spite of
an increase in the rate of dismissals, has seen turnover in the labour market decline a little.
Labour supply
Labour market outcomes also depend on the supply of labour. Like labour demand, growth in
labour supply has slowed substantially over the past year or so. This reflects both cyclical
and structural influences.
The slowing in the growth of labour supply is evident in the rate of labour force participation.
A smaller proportion of the working-age population is employed or looking for work. This
decline in the participation rate has been larger than the average experience during earlier
episodes of rising unemployment (Graph 6). So even though the population has continued to
grow at a strong rate, the growth in the labour force has been a little slower than previous
experience might have suggested.
Graph 6
It is not unusual for the participation rate to fall during periods of weak demand. As jobs
become more difficult to find (at the prevailing wage), some individuals become discouraged
from searching. These individuals may still be available to work, but they might choose to sit
on the sidelines of the labour market, ready to take up an opportunity or at least begin
searching for one when conditions improve. Discouraged individuals represent an element of
labour market slack that is not captured by the conventional measure of unemployment
because they are "marginally attached" to the labour force.4
In recent years, there has been a rise in the proportion of the working-age population that is
marginally attached to the labour force, which is consistent with a discouraged worker effect
(Graph 7). This has contributed to the decline in the participation rate - that is, a rise in the
share of the working-age population not in the labour force. But since 2010, the rise in the
marginally attached only accounts for less than one-quarter of the rise in the share of the
working-age population not in the labour force. Many of those not in the labour force may still
have been discouraged, but they chose to make themselves unavailable for work; for
example, they may have embarked on a period of study or decided to retire earlier than
might have otherwise been the case.
Graph 7
The noticeable increase in the number of people that are not in the labour force and are not
considered to be marginally attached suggests that there are other, potentially more
structural factors at play. An important one is ageing. An increasing share of the populace is
moving into older age brackets, which tend to have lower rates of participation (Graph 8).
Also, older workers are more likely to work part-time, so even those participating do so with
fewer hours on average than when they were in the prime of their working-age lives.
Graph 8
The ageing of the population is not new. By itself, ageing is estimated to have subtracted
from the participation rate by between 0.1 and 0.2 percentage points per year over the past
decade and a half (Graph 9). However, the effect has picked up a little in recent years as
baby boomers have begun to reach the age of 65 years.
Graph 9
What has begun to deviate more noticeably from its historical path in recent years is the
participation rate among older workers. In the past, rising participation of those people in
older age brackets worked to more than offset the effect of an increasing share of older
people in the population. That is, while the workforce was ageing, more people were working
later into life than was the case in the past. In particular, older women were more likely to
participate than was the case for their predecessors. But in recent years this trend increase
in the participation of older age groups has slowed, and their participation rates have been
flat or even falling a touch (Graph 10).
Graph 10
What's not clear though is why this upward trend has tapered off. It may be a response to the
cyclical weakness in the labour market, in which case participation rates of those aged
55 years and over might trend up again, in time. Alternatively, it may be more structural.
Perhaps earlier forces, including rising longevity and a general ability and preference to work
later into life, may have largely run their course. However, given the long history of rising
longevity, it seems likely that this will continue. One possibility though is that the forces
underpinning the earlier rise in participation at older ages (including longevity) have run up
against current incentives for many to retire by the age of 65 years.
However, the story of lower participation rates is not entirely about ageing and the behaviour
of older workers. Participation has also declined for other groups, most notably younger
people - many more of whom are participating in education (Graph 11). Again, these
declines may have both cyclical and structural elements.
Graph 11
Wages
While the growth rates of labour demand and supply have both been weaker over the past
couple of years, we know that the former has been more significant than the latter. The fact
that labour supply has not been constraining employment growth is evident in the rise in the
unemployment rate and the substantial decline in the growth rate of wages over that period
(Graph 12).
Graph 12
The slowing in wage growth is clear also in the leftward shift in the distribution of wage
growth across individual firms (Graph 13). The data shown here are from the NAB business
survey. This is also consistent with the Bank's liaison which suggests that wage outcomes of
more than 4 per cent have become far less common than was the case a few years ago.
Indeed, outcomes of 2-3 per cent are more common than 3-4 per cent. Slower wage growth
has also been helped by inflation expectations remaining contained.5
Graph 13
The implications of a slowing in labour demand (relative to supply) depend significantly on
the responsiveness of wages. Changes in demand will have less of an effect on employment
and output if wages respond sooner and by more than otherwise. In this respect, the more
flexible labour market in comparison to earlier terms of trade booms has been helpful. This
flexibility allowed for a rise in relative wages to encourage labour into resource and
resourcerelated activities during the run-up in mining investment, without this leading to a large rise in
the growth rate of wages across the economy more broadly. The same flexibility is helping as
the terms of trade and mining investment turn down.6
Indeed, the decline in wage growth of late has been particularly pronounced in mining and
business services, but it is evident elsewhere (Graph 14). The move from the investment to
the production phase of the mining boom is freeing up and will continue to free up labour to
move back into the non-resource sectors of the economy. This has weighed on wage growth
across the economy and is likely to do so for a while yet.
Graph 14
The slowing in wage growth across all industries has meant that firms have experienced
relatively slow growth in their labour costs. This is more striking after accounting for the
growth in the productivity of labour, which as I've already noted has picked up somewhat
compared with the pace we had become accustomed to over much of the 2000s. Over the
past year and a half, the growth in nominal wages has been matched by growth in labour
productivity. As a result, there has been no increase in the cost of labour required to produce
a unit of output.7
In turn, slower growth in labour costs is having a beneficial effect on international
competitiveness. The link between labour costs and competitiveness can be illustrated by a
measure of the real exchange rate based on unit labour costs (the real trade weighted index
(TWI) in Graph 15). This tells us about the labour cost of producing a unit of output in
Australia relative to the cost of doing so in our trading partners (both measured in equivalent
currency terms). Over the decade to 2011, the real exchange rate appreciated significantly,
consistent with the rise in the terms of trade and the mining investment boom. Much of that
occurred via the nominal exchange rate, which appreciated by a little more than 50 per cent
over that period. But part of the adjustment occurred via a pick-up in the pace of wage
growth, at a time when labour productivity growth was relatively slow. Hence, nominal unit
labour costs in Australia increased by around 25 per cent relative to our trading partners over
this same period, contributing noticeably to the decline in competiveness (outside of the
resources sector, which benefited from much higher commodity prices).
Graph 15
Now that process is beginning to change course. A decline in the real exchange rate is one
important way in which the economy can adjust to the decline in the terms of trade and the
transition to the production phase of the mining boom. Over the past year, we've seen a
noticeable decline in the nominal exchange rate, although it still remains high by historical
standards, particularly given the further decline in commodity prices in recent months.
At the same time, Australian unit labour costs have stopped rising relative to our trading
partners and even declined just a little since mid-2012. This is part of the adjustment to the
decline in commodity prices and will assist the non-mining economy regain some
competitiveness and generate employment growth as demand for labour in the resources
sector turns down. Adjustment via slower wage growth and stronger productivity growth may
not contribute as much nor as quickly to a real depreciation as might be expected from a
decline in the nominal exchange rate. However, it is still preferable to the alternative of little
or no adjustment in the growth of unit labour costs, which would come at the expense of
more unemployment and the associated economic and social costs.
Conclusions
To conclude, growth in both labour demand and labour supply has been slow over recent
years. Demand for labour has been affected by several headwinds. The downturn in mining
investment has weighed on domestic demand, while the commensurate pick-up in exports
has been less labour intensive. On the labour supply side, much of the slowdown is likely to
have had a cyclical element, although structural factors such as ageing are also playing a
role.
The slower growth of wages over the past couple of years has been a helpful part of the
process of adjusting to the downturn in commodity prices and mining investment. The decline
in wage growth has contributed, at the margins, to a turnaround in the real exchange rate
and helped cushion the effect of slower growth of domestic demand on employment growth.
It has also helped to contain domestic cost pressures thereby offsetting the effect of the
lower exchange rate on consumer prices.
The demand for labour has improved over recent months, although some of that may reflect
a "catch-up" after a period of weak employment growth last year. Some forward-looking
indicators are higher than they have been, though they are still at levels consistent with only
moderate employment growth in the next few months. The Bank's latest forecasts are for
employment growth to pick up gradually over the next two years. The unemployment rate is
expected to remain elevated over that period, declining from later in 2015 when we anticipate
GDP growth to be picking up to an above-trend pace.
Looking well beyond that horizon, demographic changes loom large and will play an
increasing role in the discussion of labour market developments. As we've suggested on a
number of occasions, in time it is likely that the availability of workers, not jobs, will be the
main concern.8[8] And in that world, one imagines that real wages might grow a little more
rapidly than otherwise, in order to encourage participation.