Question: When will Central Banks stop increasing interest rates?

Answer: Not until wage growth stabilises in the 3.5-4.5% range; the sweet spot for 2-3% inflation.

To understand what is required to stabilise wage growth, we need to understand the current labour market dynamics in the US and Australia, both are experiencing record-low unemployment rates, but the drivers are vastly different.

Rather than obsessing (like the media) over unemployment rates that can be skewed by the number of people seeking work, our preferred measure of employment is total people employed (or total hours worked) as this provides an unadulterated view of the employment market. The chart below illustrates 3 important deviations between the US and Australia:

US Net International Migration had been trending upwards from ~800k per year in 2011 to over 1 million people per year in 2016 under the Obama Administration (0.3% population growth). The election of Trump coincided with a pivot in immigration policy, with net migration falling twice as fast as it had increased, lowering the population by ~1.7 million in the three years prior to Covid.

During the same period, Australia continued to run a historically high net immigration program of ~220k per annum (1% population growth). This led to an acceleration in the total number of employed people, an increase in underemployment and persistently low wage growth (green shaded area).

In contrast, the reduced supply of labour in the US slowed the growth in total employment but reduced the unemployment (and underemployment) rate from 4.7% to 3.5% and caused the rate of wage growth to accelerate from low 2% to over 3% (grey shaded area).

The structure of covid-assistance payments for workers in the US was vastly different to Australia and many other developed countries, which opted to tether employees to their workplace by providing payments via their employers. The US scheme, however, was only available to officially unemployed persons; this led to a significantly higher fall in the number of employed people.

As economic activity resumed, employers scrambled to re-employ former or new employees with many older employees not returning to the workforce. The labour supply shock combined with increased competition for employees resulted in a step-change increase in US wages from mid-2020 onwards. By contrast, Australian wage growth dropped below 2% during the same period.

A key point missed in media coverage of record-low unemployment in the US is that total employment only reached pre-pandemic levels in September 2022 and remains well below the long-run, pre-pandemic trend. The issue stems from workers over the age of 55 exiting the workforce during the pandemic and not returning, with the workforce participation rate falling from 63.4% to 62.3%.

The US had a very tight labour market pre-pandemic and the removal of ~2.0 million workers from the market and higher economic growth has resulted in spiralling wage growth and services inflation.

Again, Australia is a case of contrast to the US. Total employment has returned to the pre-pandemic trend, with workforce participation rate increasing from 65.9 to 66.6%. Australia had significant slack in the employment market pre-covid, with unemployment at 5.3% (US: 3.5%) and high underemployment. The removal of high immigration levels during covid has tightened the labour market, but due to this slack ‘buffer’ of employable workers, it has not resulted in a large uplift in wages.

To put it simply; there is too much economic activity in the US for too few workers, and if the supply of labour cannot increase rapidly then a recession will follow.

The Fed needs to orchestrate a fall in wages growth from 5.0% down to 3.5-4.0% per annum and an increase in the unemployment rate by between 1.5-2.0%. There are two ways to achieve this:

Increase Labour supply by increasing the participation rate

Reduce the number of jobs by slowing the economy.

Increasing supply requires ~2 million re-entering the workforce and the likelihood of this is falling. Higher cost of living and lower investment returns may help reverse some of the workforce exits but it is unlikely to occur fast enough to avoid the rapid interest rate rises planned by the Fed.

This leaves the alternative of slowing the economy to reduce jobs and drive-up unemployment. History has shown that this is a difficult (if not impossible) task; the US has never had unemployment rise by over 1% without causing a recession.

On this basis, it seems more likely than not that the world’s largest economy will tip into a recession in the second half of 2023.

Australian inflation is due to overseas factors (war, energy prices, supply chains) and not by wage growth-driven services inflation. Based on the visa issuance data (below) we expect to see a surge in immigration, approaching 400,000 to 500,000 over the next 12 months.

Government policy still likes (loves) immigration. State and Federal Budgets need the population growth 'sugar fix'. The cost is low real wages growth, low per capita growth, and strained public services, but the upside is lower interest rates and increased tax revenue.

If immigration does significantly materialise, then inflation will be a rear-vision issue and the economy will look & feel like pre-Covid. We would expect to see a pivot in monetary policy to falling rates with significant (positive) implications for property, rents, and valuations.

Cameron Harrison have been advising business owners and their families on asset allocation and intergenerational wealth management for over 50 years. We have demonstrated over a long period our ability to manage investments through both the good times and bad by keeping the client at the centre of our business. 

For more information on our approach to investment strategy or any other inquiries, please contact us on +613 9655 5000.