RBA’s labour market call risks overtightening the economy

Current rates could unnecessarily weaken growth and employment if the RBA misjudges the tightness of the labor market, writes Stephen Koukoulas.

As part of the interest rate decision-making process, the Reserve Bank of Australia (RBA) attempts to estimate the strength or tightness of the labor market.

This is not because he wants to see unnecessarily high unemployment in Australia. On the contrary, it wants to ensure that the economy can grow at a pace where everyone who wants a job can find one relatively easily and quickly, while at the same time ensuring that inflation is at the midpoint of the 2-3 percent target range.

This is the broad definition of full employment.

There has been a lot of mixed news in recent months about the strength, or lack thereof, of the labor market. This uncertainty did not stop the RBA from predicting that labor market conditions were “tight”.

This interpretation is controversial and important because if the RBA is wrong the consequences will lead to a materially weaker economy between 2026 and 2027.

inside minute At the RBA Board meeting in February, when it raised interest rates to 3.85%, he noted:

“The labor market was slightly tighter than is consistent with full employment.”

It is difficult to assess in real time whether the economy is operating at a level consistent with “full employment.”

Reference is often made to the unemployment rate, underemployment, participation rate, employment to population ratio, job vacancies and wage growth.

All of this has some validity, but from the perspective of monetary policy and future inflation, the level of wage growth is the strongest indicator for assessing the degree of labor market stagnation.

Think about it.

If the labor market is truly tight, employers will have difficulty finding new workers or retaining talent in their business operations. There will be a labor shortage. There will be fewer job openings.

When there is a shortage, prices increase

Like any service with high demand, the result of a tight labor market will be a higher price for labor; in other words, wage increases to retain staff and attract new staff. If the labor market was really tight, wage increase It will accelerate and progress at a high pace inconsistent with the RBA’s inflation target.

wage price index data Only modest growth in wages has been confirmed for the December 2025 quarter. This has been the case for the last 18 months, with annual wage increases generally between 3.25% and 3.5%.

This rate of wage growth is fully consistent with inflation, which is 2.5 percent.

Moreover, job openings and postings remain well below their peaks, indicating that labor demand is not that strong. In particular, job vacancies fell by 30% compared to 2023, confirming a significant weakening in labor demand from employers. Under these circumstances, there is little or no need to pay higher wages to attract or retain staff; this is also reflected in wage price data.

There are other key indicators that the labor market is softening.

These can be broadly described as “disheartened workers” or people who have left the labor market.

The labor force participation rate fell sharply last year, dropping 0.5 percentage points from 67.2% to 66.7%. The participation rate tends to increase when the economy is strong and the labor market is tight. Economic vitality and the relative ease of finding a job draw people back into the labor market, increasing labor force participation.

The ratio of employment to population is a similar problem. dived It rose to 63.9% in the latest data, up from 64.5% a year ago.

The falling participation rate and the lower employment-to-population ratio last year suggest that a large portion of the working-age population could re-enter the labor market if conditions warrant such a move. This can happen without lowering the unemployment rate.

Discouraged workers can re-enter the labor market without undue wage and inflation pressures.

The recent unemployment rate of 4.1%, while historically low and good news, may not fully reflect the tightness of the labor market.

There is nothing at this stage to suggest that an unemployment rate close to or below 3.5% cannot be achieved with inflation at the RBA target. This may be the new normal.

All of this has significant implications for the RBA’s assessment of economic conditions.

If the RBA is wrong, the current level of interest rates, let alone further rate hikes, will risk eroding growth and damaging labor market conditions.

Short-term noise in some parts of the labor market is open to over-analysis and over-interpretation.

From an inflation perspective, wage growth is the dominant indicator of tightness in the labor market, and the latest news is positive in this regard.

Stephen Koukoulas is one of Australia’s most respected economists, the former chief economist of Citibank and senior economic advisor to the Australian Prime Minister. You can follow Stephen on Twitter/X @TheKouk.

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