Geoff Bascand: Inflation pressures through the lens of the labour market
Speech by Mr Geoff Bascand, Deputy Governor and Head of Operations of the Reserve
Bank of New Zealand, to Otago University, Dunedin, 7 April 2016.
* * *
I wish to thank my colleagues at the Reserve Bank whose research on the labour market I have drawn upon in
preparing these remarks, and in particular Miles Parker and Evelyn Truong. References can be found in the
footnotes.
Introduction
Thank you for inviting me to speak today. It was a pleasure speaking as part of the Visiting
Executives Programme last year, and even more so to have been invited back. Today I want
to consider inflation pressures through the lens of the labour market. We have seen some
extraordinary developments in the New Zealand labour market over the past three years and
these pose challenges to our modelling of inflation pressures.
Employment in New Zealand has increased by 180,000 or 8.3 percent over the past three
years. In previous periods of very strong employment growth, such as the mid-2000s and the
mid-1990s, wage growth accelerated. In the current cycle it has remained moderate. Even in
Canterbury, with the demand pressures from rebuilding Christchurch and unemployment
falling to around 3 percent last year, wage growth has been modest.
Over the same period, we have experienced the largest recorded surge in immigration in
more than 100 years, but without the generalised inflation pressures that accompanied the
previous migration wave. The proportion of the population participating in the labour force
reached record levels in 2015 and labour force growth has averaged about 2 percent per
year since 2012, well above expectation (Figure 1).
The Reserve Bank has undertaken considerable research over the past year on the impact
of migration, labour market slack, and wage bargaining by New Zealand businesses. I will
discuss what we have learned and the implications for monetary policy.
To cut to the chase, recent low consumer price inflation can be mostly explained by falls in
commodity prices and the high New Zealand dollar. However, the higher productive capacity
of the economy from rapid growth in the labour force, much of which was unexpected three
years ago, explains some of the remaining weakness in inflation.1 Strong labour force growth
has had a moderating influence on wage inflation, and the migration cycle, in particular, has
had lower inflationary impact than expected.
I'll begin by discussing how developments in the labour market affect inflation and monetary
policy.
Labour supply, demand and monetary policy
Monetary policy works to meet our inflation target by setting interest rates to keep current
economic activity close to its long run, sustainable level (i.e. potential output).2 When the
level of output exceeds potential - that is to say there is a positive output gap - inflation
tends to accelerate. Similarly, inflation tends to fall when the level of output is below
potential.
There are a number of measures of the output gap, but the balance of labour demand and
supply is a central feature in most of them. It determines the cyclical impact on
unemployment, wages and consumer prices (this relationship, known as the Phillips curve,
was originally specified between wages and unemployment but is now often modelled
between consumer price inflation and output).3
There is always some unemployment since it takes time to find a new position and the skills
of job seekers may not match up with current vacancies.4 For example, many part-time
workers in hospitality and retail were made redundant following the Canterbury earthquakes,
whereas the vacancies arising from the rebuild are typically full-time construction jobs.5
When the level of unemployment deviates from its long-run "natural rate" it puts pressure on
wages, in a similar fashion to the output gap and prices. When unemployment is below its
natural rate, additional workers are relatively scarce and businesses will have to increase
wages to entice people to seek work (from non-participation) or to move from other
businesses. These higher wages increase business costs and put upward pressure on
output prices. Indeed, labour costs are the factor most likely to cause price changes
1
See McDermott, J (2015), "The dragon slain? Near-zero inflation in New Zealand", Assistant Governor and
Chief Economist, Reserve Bank of New Zealand, speech delivered to the Waikato Chamber of Commerce and
Industry and Waikato branch of the Institute of Directors, Hamilton, 23 April.
2
Potential output and monetary policy in New Zealand is discussed at length in McDermott, J (2014),
"Realising our potential: Potential output and the monetary policy framework", Speech by John McDermott,
Assistant Governor and Chief Economist, Reserve Bank of New Zealand, 9 July.
3
McDermott (2015), op cit.
4
These frictions are modelled in more detail for New Zealand in Albertini, J, Kamber, G and Kirker, M (2012),
"An estimated small open economy model with frictional unemployment", Pacific Economic Review, 17(2):
326-353.
5
Furlanetto, F and Groshenny, N (2012), "Matching efficiency and business cycle fluctuations", Reserve Bank
of New Zealand Discussion Paper, 2012/06, study the impact of changes in matching efficiency on US
business cycles, finding that the impact can vary depending on the type of hiring costs faced by firms. Craigie,
R, Gillmore, D and Groshenny, N (2012), "Matching workers with jobs: how well is the New Zealand labour
market doing?", Reserve Bank of New Zealand Bulletin, 75 (4, December): 3-12, discuss the New Zealand
situation, highlighting the increased matching inefficiency in Canterbury following the major earthquakes there
in 2010 and 2011.
according to a recent survey of New Zealand businesses.6 Conversely, high unemployment
puts downward pressure on wages and prices.
With that framework in mind, we can look more closely at the factors driving the market and
the consequences for inflationary pressure.
Labour supply
The labour that is available to be employed (labour supply) is determined by three main
factors.7 First, is the working age population, itself a function of demographics and migration.
Second, is the share of the working age population that participate in the labour force, either
by working or by actively seeking work (the participation rate). Third, is the amount of time
(number of hours) that people in the labour force are willing to work.
Average hours worked per person have changed little recently. The main drivers of the rapid
growth in labour supply are participation and population increase (figure 2).
Many of the underlying demographic trends affecting the labour force are slow moving, and
do not tend to affect monetary policy decisions from quarter to quarter. They do, however,
have bearing on the conduct of policy, affecting long-run supply capacity, potential growth
and neutral interest rates, so generally it is appropriate to consider both structural and
cyclical forces.
Not so long ago, the then Government Statistician8 projected the coming decades would
exhibit much slower growth in the labour force and painted a picture of rising labour
shortages - albeit over a fifty year horizon. In contrast, labour supply has been growing very
rapidly, with cyclical forces dominating the longer-term lower trend.
Participation
The share of the population participating in the labour force, either by working or actively
seeking work, has trended higher over the past 15 years, reaching around 69 percent in
2015. The main influences on this trend have been the ageing population, increased
participation of older workers, and increased participation of women (figure 3).
Figure 3: Contributions to change in labour force participation since 20019
As in many advanced economies, our population is ageing. Because older cohorts, and
particularly those past retirement age, have a lower participation rate than the rest of the
working-age population, an increase in the proportion of older cohorts, all else equal,
decreases the aggregate participation rate.
We've also experienced a significant increase in the participation of older workers, due to
improved health and changes to retirement policies that encourage people to remain in the
workforce for longer. The participation rate of the over-60s has increased from 14 percent in
2001, to 35 percent currently. This greater participation of older workers has exceeded the
negative impact of the ageing population.
Over the past 15 years, the participation rate of females has trended upwards, as social and
cultural factors are seeing more women enter the workforce across all age groups. By
contrast, the participation rate of men has been broadly stable.
Participation can be cyclical because strong employment and wage growth encourage
people to seek work, who otherwise would not choose to participate. Similarly, during
downturns when unemployment rises and people spend longer time out of work, some are
discouraged from seeking work and no longer participate in the workforce. A recent example
of cyclical impact is Canterbury, where the strong rebuild activity encouraged additional
workers to join the labour force. Participation in Canterbury rose from 67 percent at end-2011
to around 72 percent at the end of 2015, 4 percentage points above the rest of the country.10
Research underway at the Bank has identified there are large flows of people from outside
the labour force directly into employment. This flow from non-participation into employment is
much higher than that witnessed in other countries.11 Around two thirds of the newly
employed - those who are employed in the current quarter but who were not employed in the
previous quarter - come from non-participation, while only a third of the newly employed
were unemployed in the previous quarter.
One implication is that participation is potentially more sensitive to cyclical variation than
previously thought. Another is that the unemployment rate is a weaker indicator of labour
market slack and inflationary pressure than previously assumed. I will return to the
measurement of slack later.
Population
In recent years, the main driver of population growth has been immigration, which is running
at its highest rate for a century (figure 4). Net immigration has added about 130,000 people
(3.5 percent) to the working age population in the past three years, and is projected to add a
further 120,000 by 2018. Given its importance, I want to explain how migration affects the
economy.
Migration increases aggregate demand in the economy. New arrivals require goods and
services, and their household spending puts upward pressure on inflation. With housing
supply fixed in the near-term, higher demand for housing increases rents and house prices
and eventually encourages residential investment. The boost to demand from migrant
spending and increasing activity generates additional demand for labour.
However, recent work at the Reserve Bank12 suggests that the current migrant inflow may be
having a smaller impact on demand and inflation than in previous cycles, partly due to the
higher share of young migrants (figure 5). The study finds that younger migrants (17 to 29)
have a smaller impact on inflation and real house prices than older migrants. This is probably
because younger migrants arrive with fewer financial assets, spend less, and are less likely
to purchase a house.
Migration also boosts labour supply. In this cycle, fewer families and more work visas are
likely to have boosted migrant participation. While students usually have lower participation,
the recent relaxation of rules allowing migrants on student visas to work up to 20 hours per
week may have boosted participation.
Since migrants boost both supply and demand in the economy, the net effect on inflationary
pressure can be ambiguous. Our historical experience has been that migration increases
inflationary pressures in product and housing markets. In the current cycle, however, the
migration drivers have been very different and recent research13 suggests that these
differences matter for labour market outcomes.
In particular, when migration is caused by weakness in the Australian economy (or the rest of
the world), it increases labour supply at a time when our businesses are facing lower
demand, and hence need less labour. This results in higher unemployment and lower
inflationary pressure.
Much of the current surge in net immigration is explained by weakness in the Australian
labour market that has made New Zealand a relatively more attractive place to live.
Fewer New Zealanders are departing for Australia, more are returning home, and foreign
migrants who may have considered migrating to Australia are coming to New Zealand. The
flow of net emigration to Australia has reversed over the past 12 months, and is the largest
net inflow for 25 years.14
The differences in the composition and drivers of migration in the current cycle help explain
why inflationary pressures have been more muted than expected.
Labour demand and employment
Following the 2007-08 global financial crisis, employment fell by over 55,000 in 2009. Since
then, labour demand has recovered strongly (figure 6) and employment increased by over
8 percent in the past three years, well in excess of historical average growth rates. Higher
household consumption arising from strong population and tourism growth and the
Canterbury rebuild were major drivers of the employment growth, with jobs in construction
accounting for more than a quarter of total jobs growth over the past three years.
Labour market slack, wages, and inflation
Having discussed the underlying causes of the recent strong growth in the labour force, I
would like to conclude by discussing the implications for monetary policy.
The labour market most directly influences consumer price inflation through wage outcomes.
This is particularly true of non-tradables goods and services, where labour represents a
higher share of the total cost of production.15 Broadly speaking, wage outcomes are
determined by three factors: labour productivity, inflation expectations and the balance
between the demand and supply for labour.
In the long run, growth in real wages - that is, wage growth beyond the change in consumer
prices - should reflect labour productivity. Labour productivity in New Zealand has averaged
only 0.8 percent per year since the global financial crisis, thereby limiting the increase in
wages due to this factor.
Wages affect consumer prices, but the relationship is complex and flows in both directions.
Current and expected rates of consumer price inflation are factored into wage-setting.
Recent research by the Bank highlights this relationship, with the majority of businesses,
weighted by employees, reporting a direct or indirect link between inflation and wages.16
Other work has found that wage inflation expectations bear a closer relationship to past
inflation outcomes than previously thought.17 In the March 2016 MPS, we expressed concern
that recent declines in indicators of inflation expectations could become embedded in low
wage settlements, thereby subduing inflation outcomes.
Over the business cycle, a key driver of wage growth is the balance of supply and demand,
or labour market "slack". However, the unemployment rate is an inadequate indicator of
labour market slack, particularly when the participation rate fluctuates. Researchers at the
Bank have recently constructed a labour utilisation composite index, or LUCI, to help address
this problem. Such indices combine the information in a large number of labour market
variables into a single series of labour market tightness, and are used internationally to help
gauge labour market pressures.18 The New Zealand index uses official statistics such as the
HLFS and survey measures of the difficulty of finding labour, such as the QSBO.19
By construction, the LUCI has an average value of zero. A LUCI value above zero indicates
greater labour market tightness than usual - a value below zero indicates greater labour
market slack than usual. Our research shows that, historically, a higher LUCI has been
associated with stronger wage growth.
The LUCI suggests there was a large degree of slack in the labour market at the trough of
the 2008-09 recession. The LUCI then gradually returned to zero, and has been around that
level since early 2014 (figure 7). This movement is consistent with the range of the Bank's
suite of output gap indicators.20 With labour market conditions broadly in balance since 2014,
there has been little additional upward pressure on wages recently.
Nominal wage growth is currently around 1.6 percent per annum, noticeably below the rates
witnessed in the mid-2000s (figure 8). Current wage growth is consistent with our models
16
See Armstrong, J and Parker, M (2016), "How wages are set: evidence from a large survey of firms",
Reserve Bank of New Zealand Discussion Paper, 2016/03.
17
Lewis, M., McDermott, J., and Richardson, A., (2016), "Inflation expectations and the conduct of monetary
policy in New Zealand", Reserve Bank of New Zealand Bulletin, 79 (4, March).
18
See Yellen, J (2014) "Labour market dynamics and monetary policy", Chair, Board of Governors of the
Federal Reserve System, Speech given at the Federal Reserve Bank of Kansas City Economic Symposium,
Jackson Hole, for the use of an LUCI in the context of monetary policy discussions in the United States. The
construction of the US LUCI is detailed in Hakkio, C and Willis, J (2013), "Assessing labor market conditions:
the level of activity and the speed of improvement", Federal Reserve Bank of Kansas City, The Macro Bulletin,
July 18.
19
See Armstrong, J, Kamber, G and Karagedikli, O (2016), "Developing a labour utilisation composite index
for New Zealand", Reserve Bank of New Zealand Analytical Note, 2016/04. Preliminary analysis of Statistics
NZ's new experimental monthly filled job series suggests it improves the LUCI and provides an earlier
indication of changes in labour market slack.
20
See Armstrong, J (2015), "The Reserve Bank of New Zealand's output gap indicator suite and its real-time
properties", Reserve Bank of New Zealand Analytical Note, 2015/08.
and the outturns we have experienced for productivity, inflation expectations and labour
market slack.
That current wage growth is lower than we expected two years ago reflects a slower than
anticipated reduction in slack due to the unexpected increase in the labour force from
migration, weak productivity growth and lower than expected headline inflation, particularly
from oil and other tradable prices.
Despite the lower nominal wage growth, real wage growth has been historically high. Given
the sluggish performance of labour productivity, this high real wage growth likely reflects the
downward surprises to headline inflation. In the absence of higher labour productivity growth,
these recent increases in real wages are unsustainable in the long run.
Concluding remarks
In the past four years, New Zealand's population has grown by a quarter of a million people,
with over half that number coming from overseas. The migration surge has contributed to
housing and consumer demand but had less impact on inflation than in previous migration
cycles.
The New Zealand economy has expanded steadily since 2011, with strong employment
growth. Notwithstanding the 180,000 extra jobs, the unemployment rate has declined only
modestly.
The surge in net migration, together with higher labour force participation from women and
older workers, has led to rapid labour force growth and an increased supply capacity of the
economy. A new measure of labour market slack (the LUCI) suggests that labour supply and
demand are broadly in balance.
Unexpectedly strong growth in labour supply, along with the characteristics of the migration
cycle, substantially explains why wage and non-tradables inflation pressures have been
weaker than expected. Stronger than expected labour supply, and greater than expected
slack, has been a factor in in our assessment that it has been appropriate to keep monetary
policy accommodative.
In view of the close relationship between labour market dynamics and inflation pressures, we
will continue to monitor a broad range of labour market indicators to help inform our
monetary policy decisions.