Brian Fallow: More jobs but wage growth lags

One of the striking features of the economy lately is that five years of above-average economic growth and the tightest labour market in a generation have not been accompanied by runaway wage inflation.

But wage pressure has been mounting, and last week there was something of a clamour for the fruits of economic growth to be more widely distributed through higher pay. It's now or never, seems to be the message.

Easier said than done. For better or worse, New Zealand has moved over the last 20 years from a system in which people's ability to command higher wages depended on the ability to strike, to one in which it depends on an individual's ability to find a better-paid job elsewhere.

It is a system that has proved better at creating jobs than at delivering higher standards of living.

Labour shortages have become a hobble on many companies' ability to expand. In the Institute of Economic Research's latest quarterly survey of business opinion, one firm in four cited labour as the single factor most limiting the ability to increase turnover.

That was up on September, and the highest level for 30 years. Unsurprisingly, the problem was most acute in the construction sector.

Another indicator from the survey, the number of firms reporting difficulty in finding skilled workers, suggests upward pressure on wages for the next two years.

Based on past relationships and lags, the institute says these results indicate average wage growth of about 3.7 per cent this year and 4.2 per cent in 2006.

But with inflation nearing the top of the Reserve Bank's 1 to 3 per cent target band, such figures represent pretty modest real wage growth.

Westpac chief economist Brendan O'Donovan says that traditionally such a tight labour market would raise the spectre of wage-induced inflation, which would require the Reserve Bank to lift interest rates or keep them high for longer.

But so far at least, wage inflation has been well-contained, he says.

One reason is that the deregulation of the labour market has meant that the "growth dividend" has come in the form of more jobs rather than higher wages for existing workers.

The 56,000 new jobs created in the year to September pushed the unemployment rate down to 3.8 per cent. That is the lowest for 18 years, second-lowest among rich countries and compares with 5.3 per cent across the Tasman.

Employment growth has made inroads into parts of the population often disadvantaged in the labour market: the long-term unemployed, the over-55s, women and Maori.

While this is desirable, it is not a trend that can continue forever.

The second factor O'Donovan cites as keeping wage inflation relatively weak, the openness of the economy, means many producers are competing in a world awash with spare capacity and do not have the pricing power to pass on higher wage costs to their customers.

Wage growth has been stronger in those parts of the economy where external competition is limited or non-existent, such as the public sector and the building industry.

Last year, inflation in the tradeables sector of the economy, which is subject to international competitive disciplines (and the exchange rate), was 0.7 per cent; in the domestic or non-tradeables sector it was 4.3 per cent.

The trouble is that when the exchange rate weakens that external constraint will also weaken.

Because there is no free lunch, the money for higher wages has to come from somewhere.

The options basically are higher productivity (so that labour costs per unit of output do not rise correspondingly), higher consumer prices or lower profit margins.

So far the evidence of a pick-up in productivity is tentative, although there are encouraging signs of the kind of increase in investment by firms in the plant and machinery required if productivity is to rise.

The option of raising consumer prices, of course, would be something of an own-goal if it triggered higher interest rates from the Reserve Bank.

The bank can take some comfort from the fact that in the latest business opinion survey the number of firms saying they intend to raise their prices was lower than in the previous poll, even though capacity constraints both in plant and labour remain at high levels. But the prospect of a "bow-wave" of wage demands could give the central bank palpitations, says ANZ National Bank chief economist John McDermott.

"With inflation already sitting uncomfortably high and likely to stay that way for some time, excessive wage demands could set in play a spiral of inflation-induced wage demands, which raises unit labour costs, places further pressure on inflation, necessitating higher wage demands and so on."

That sort of wage-price spiral is exactly what the Reserve Bank has a statutory obligation to pre-empt. Growth would be sacrificed to preserve price stability and everyone would lose.

Unit labour costs have been persistently running above those in Australia or the United States, says McDermott, because of our weaker productivity performance.

"Failure to keep the lid on unit labour costs will weaken New Zealand's competitiveness, which is already being undermined by a high New Zealand dollar."

And if wage settlements do rise in the name of catching up, the ultimate trade-off could be fewer people in jobs, he warns.

"As a rough rule of thumb, each 1 per cent increase in wages above levels justified by the economic fundamentals eventually implies a 0.5 [percentage point] change in the unemployment rate, or 5000 fewer people in jobs."

The economic fundamentals that wage rises should broadly mirror over the long run are inflation plus productivity growth.

By and large they have. Average wage growth over the past 10 years, as measured by Statistics NZ, was 3.1 per cent a year.

Over the same period inflation has averaged 2 per cent and labour productivity growth 1.3 per cent on a head count and 1.4 per cent on the basis of hours worked.

What then of the argument, advanced by the Council of Trade Unions, that at a time of good corporate profits employers can afford to pay more? After all, five months into the current fiscal year the company tax take, a rough proxy for profits, was up 18 per cent on the same period a year earlier.

O'Donovan says that between 1994 and 2000 national income was pretty evenly split between labour (compensation of employees) and capital (gross operating surplus).

"However, since 2000 the share has again moved in favour of capital, despite the low unemployment rate."

O'Donovan says that as the domestic economy cools this year, employers' ability to pass on costs to consumers will be crimped, suggesting that profit margins will absorb at least some of the additional labour costs next year.