Australian Opposition Leader Bill Shorten has declared the next federal election a ‘referendum on wages'. Unfortunately, we can’t just vote ourselves a wage increase. Productivity growth is the only sustainable source of real wages growth.

The relationship between productivity and wages has weakened somewhat in recent years and not just in Australia. In the United States, some have argued that there has been a decoupling of wages from productivity such that workers are no longer enjoying the benefits of greater prosperity, feeding into a broader debate about income inequality.

The ‘decoupling’ thesis typically focuses on the relationship between productivity and the median wage to suggest that the typical worker in the middle of the income distribution has not benefited from increased productivity. But economic theory does not necessarily predict a strong relationship between productivity and median wages. Indeed, it implies very little about the distribution of the income gains from increased productivity.

Productivity growth is expected to raise wages on average, but the distribution of those gains is a function of a wide-range of other factors. Those who argue that the relationship between productivity and compensation in Australia and the United States is broken are mostly looking at the wrong measures.

When measured more appropriately, the long-run relationship strengthens, although there is still evidence for a weaker relationship more recently. But this does not mean we should rush to abandon competitive models of wage determination. Prior to the move away from centralised wage fixing in the early 1990s, the link between productivity and compensation really was broken. The Hawke-Keating government’s Prices and Incomes Accord with the unions sought to suppress real wages growth to allow productivity to catch-up with the excessive wage gains of the early 1980s.

The danger in confusing the issue of productivity growth with the distribution of income is that it may lead policymakers to neglect productivity-enhancing policies on the basis they won’t benefit the typical worker. But distribution of income gains is a second-order issue compared to the first-order issue of generating those gains in the first place. Paul Krugman famously said that productivity growth isn’t everything, but in the long-run, ‘it’s almost everything.’

Unfortunately, the politics of increased productivity growth is much harder than the politics of redistribution. Both sides of politics have increasingly neglected the former in favour of the latter. Weakness in real wages has also been coupled with weakness in nominal wages. Based on the wage price index, nominal wages growth has been running at 2.3 per cent. Reserve Bank Governor Philip Lowe has said he would like to see a return to wages growth beginning with a ‘3’, that is, at least 0.7 percentage points faster that the latest growth rate.

Unfortunately, the politics of increased productivity growth is much harder than the politics of redistribution. Both sides of politics have increasingly neglected the former in favour of the latter.

As it happens, inflation is currently running 0.7 percentage points below the central tendency of the Reserve Bank’s 2-3 per cent target range. While there is not a mechanical or necessarily contemporaneous relationship between consumer price inflation and wages growth, returning inflation to the middle of the target range would go a long way to restoring the nominal wages growth Governor Lowe says he wants.

One of the main influences on the wage setting behaviour of employers and employees is inflation expectations. Together with productivity growth, low inflation expectations largely explain recent weakness in nominal wages growth.

The Reserve Bank has focused attention on the supposed puzzle of weak wages growth coexisting with a tightening labour market and the weaker relationship with productivity growth, but has largely ignored the contribution of the variables for which it is most responsible: inflation and inflation expectations. The Reserve Bank expects a tightening labour market to gradually lift both wages and inflation without having to adjust monetary policy to a more accommodative stance, but this gets the relationship between monetary policy, inflation and wages backwards.

The Reserve Bank has undershot the middle of its inflation target since the end of 2014. It has left monetary policy on hold for more than two years, the longest period of steady official interest rates on record. Monetary policy has explicitly traded-off the inflation target against apprehended financial stability risks, but those risks have abated as credit growth has slowed and the housing market has turned down.

Like below target inflation, low nominal wages growth is partly a policy choice by the Reserve Bank, a choice that also constrains fiscal policy through income tax receipts. In aggregate, nominal wages has a close relationship with nominal gross domestic product (GDP). A nominal GDP target would effectively target nominal wages.

After the federal election, the treasurer would do well to renegotiate the policy agreement with the Reserve Bank to ensure that it better prioritises the inflation target.