Low Inflation

The Australian Experience

The Australian economy aims to achieve an average rate of inflation of between 2% and 3% per annum over the course of the business cycle. As such, we can say that we have generally been able to achieve our goal in regards to low inflation during the last five years.

This is reflected in the graph below. Although we have achieved results outside the goal range, the average rate of inflation has generally been between 2% and 3% as is desired. However, since 2006/07 this outcome has been far more difficult to achieve.

Inflation in Australia

As you can see, the graph shows changes for both the headline rate of inflation, and also the underlying rate (excluding volatile items). By June 2007, the annual headline rate of inflation was recorded at 2.1%, which is at the bottom end of the acceptable goal range. During 2007/08, inflation increased outside of this range, peaking at 4.5%. Despite this, by this time the RBA had started adopting a strong expansionary stance to monetary policy, reflecting the shift to full employment as the main goal being pursued at that time. This was largely due to the fundamental shift in the economy that was occuring as a result of the emerging crisis.

The impact of the global financial crisis is evident in the graph above. Poor demand side conditions resulting in lower levels of economic activity. As the unemployment rate started to increase, the inflation rate fell. By June 2009 the inflation rate was recorded at 1.5% - a figure that is below the goal range. Despite this, the RBA was keen to ensure that people understood that the issues facing the economy before the crisis had not yet abated. By the last quarter of 2009 the RBA was acting to increase the cash rate despite the very low rate of inflation that had been recorded at that time.

The headline rate of inflation increased above 3% in 2010 and 2011. While this was partly due to strong demand from China and a quick recovery from the financial crisis, it is also true that natural disasters at the beginning of 2011 also had an impact. This is reflected in the difference between the headline rate and the rate excluding volatile items. For example, the price of bananas increased significantly during this period. The impact of this change is seen in the headline rate, but has been removed from the underlying rate. The RBA is far more concerned with the underlying rate, which is why they were able to cut the cash rate to 4.5% in November 2011 despite the fact that the September quarter data still suggested that headline inflation was well above the goal range.

The real dangers now for inflation in Australia are the supply side concerns. Lower levels of productivity, combined with higher oil prices have resulted in a rate of inflation which is outside of the goal range. Changes to the cash rate are not an effective way of targeting supply side concerns, and as such other avenues need to be explored. If the government can not find a way to address these problems, then either the rate of inflation will be higher, or interest rates will need to increase. This could come at the cost of lower rates of economic growth, and higher levels of unemployment.

Current Page: The Australian Experience