The productivity/unit labour cost conundrum

Let’s start with the RBA’s assessment that depressed productivity growth and rising unit labour costs are an issue that they need to be mindful of when setting policy.

Both issues are mentioned in the text accompanying the RBA’s latest rate decision and also in Governor Philip Lowe’s 5 April speech on Monetary policy, demand and supply. 

In the view of this author, productivity is a much-misused concept. It sounds real enough, but it is a construct of both economic growth and employment (whether measured as the number of jobs or hours worked). In a sense, therefore, productivity doesn’t really exist at all but is simply a residual that drops out of consideration of these other concepts. So, if you know what is happening to GDP growth, and you know what is happening to employment or hours worked, productivity measures add nothing to your understanding of the economy and are basically just a ratio of these other measures.

The same goes for unit labour costs, which can be thought of as output per unit of wages. We could write these relationships in the following simplistic way:

• Productivity = Output/Labour
• Average Wages = Wages / Labour
• Unit labour costs  = Output / Wages (or re-arranged  = Productivity/average wages)

And all these measures are quite cyclical. Output slows in a recession. So does employment, though it tends to lag well behind GDP and slow much later. Wages growth lags even with these changes in employment.  

The result is that in an economic slowdown, productivity drops, and unit labour costs rise. And yet this is not in the slightest bit inflationary, because the overarching piece of information is that the economy is slowing, and that will lead to weaker price pressures. This is as true for Australia as it is anywhere else, where productivity has been declining as growth has slowed, and unit labour costs have risen. And we are still looking for inflation to fall.

Contributions to QoQ GDP (pp)