Why Australia’s productivity slump matters for inflation, cash rates, house prices, wages and living standards

Reserve Bank governor Michele Bullock has again put weak productivity at the heart of Australia’s inflation problem, warning that living standards will struggle to improve as the economy heads towards its weakest stretch of growth since the 1990s.

On Tuesday, the RBA left the cash rate unchanged at 4.35 per cent, but set alarm bells ringing by downgrading its labour productivity forecasts, to a fall of 0.5 per cent for the rest of 2026.

Labour productivity and its relationship to inflation can be a complex concept. But understanding why it matters to economists and living standards reveals a policy path to escaping the downturn.

If an economy cannot produce more goods and services with the same amount of labour and capital, it becomes harder to lift living standards without generating inflation.

An example of labour productivity’s importance to wealth creation is a farm.

How do you grow more food from the same piece of farmland? Around 1,000 years ago heavy ploughs were invented in Northern Europe to mean more food could be grown from the same output per head of farm worker. This drove down the cost of producing each unit and allowed wages to rise.

The excess food grown created also surpluses and wealth that could be funnelled into more equipment, consumption, profit, or leisure time.

This basic labour productivity dynamic still drives modern economic growth.

But on Tuesday, the RBA’s latest forecasts now predict Australia’s labour productivity will turn to negative 0.5 per cent over the second half of 2026.

“Yes, we’re concerned because the productive capacity of the economy is not growing,” Bullock told reporters.

“As long as the productive capacity of the economy isn’t growing, we cannot grow very fast without running into inflationary pressures. So yes, we’re concerned.”

The Governor’s warning on falling productivity is straightforward. If less food is being grown per head of farm worker, then still equal demand for the food will push up prices.

Weak productivity therefore makes it harder for the central bank to cut rates without risking more inflation and acts as a brake on economic growth.

Record Labor government spending

AMP chief economist Shane Oliver argues the productivity problem has been compounded by the scale of Labor Government spending that has reached a record 28 per cent of gross domestic product (GDP).

The huge government spending is also contributing to the inflation that has outpaced wages growth since 2021.

Oliver says consumer prices are up 25 per cent since 2021, but average wages only up 19 per cent.

This explains why living costs seem to have climbed at a scarily high pace since the pandemic.

“Because the economy is no longer as efficient as it used to be in boosting the supply of goods and services to meet any pick up in demand, or spending, in the economy – as we saw last year when private sector demand picked up – an acceleration in growth is more likely to result in a higher rate of inflation than used to be the case for any given level of GDP growth,” he says.

Part of the problem is record levels of government spending is being directed into the public sector at the expense of the private sector.

Put bluntly, public sector workers are less efficient and produce less output per hours worked than their private sector peers.

Elsewhere, Labor’s decision to hike investment taxes to between 30 per cent and 47 per cent of all capital gains has also raised worries about the tax changes’ worsening impact on productivity.

Big productivity gains and rises in living standards are usually unlocked via investment.

Advanced, heavier ploughs are a classic example of an investment return and productivity boost in economic textbooks.

Today, the equivalent might be high-tech computer chip manufacturers boosting productivity across North East Asia in particular.

In the US, artificial intelligence is producing productivity gains to boost profits, while capping inflation and leading to higher wages.

Some tech evangelists like, Elon Musk, even argue the excess surpluses from AI-linked productivity gains will mean humans work less, for more, in a future of abundance.

Australia is facing the opposite dynamic. Productivity is now forecast by the RBA to fall into negative territory over the rest of 2026.

Governor Bullock has been reluctant to publicly criticise government spending and tax hikes as contributing to the problem.

But AMP’s Dr Oliver is more blunt.

“The problem is that since the GFC, and reinforced by the pandemic, the political pendulum has been swinging in favour of bigger more interventionist government,” he says. “There is now an expectation that government is the solution to most problems.”

Policies to boost productivity

Oliver argues the policy response should focus on restoring incentives for investment and productivity to boost living standards again.

His recommendations include limiting government spending to 25 per cent of GDP and requiring additional spending to be offset by cuts elsewhere.

He also advocates greater labour-market deregulation and tax reform designed to encourage private investment rather than discourage it under Labor’s 2026 Budget.

“The capital gains tax changes threaten startups and hence productivity,” Oliver says. “Provide more incentives to boost investment and adopt new technology. There was a bit of this in the Budget but it was modest.”

The problem for the RBA is that it cannot just cut interest rates to end the economy’s ongoing malaise.

Without productivity improvements every time the central bank cuts rates inflation is likely to rise. This is because the economy cannot expand without running into capacity constraints that translate into higher prices and inflation.

That is why Bullock’s warning about productivity matters beyond the RBA’s next rate decision on Melbourne Cup Day.

If Australia cannot find ways to produce more with the labour resources it already has, faster economic growth will be difficult and gains in real living standards elusive.

For all the attention paid to interest rates, house prices, and inflation, productivity is still the most important driver of rising wealth.