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 2005/06 this outcome has been far more difficult to achieve.
By 2005, the rate of inflation had increased to 2.5%, which is right in the middle of the acceptable goal range. During 2006, inflation crept outside of this range, peaking at 4%. A contractionary monetary policy stance in that year, followed by two more increases to the cash rate in 2007, saw the rate of inflation fall to within the goal range once again. However, the underlying pressures that were evident in 2006 were certainly not resolved at this time. By September 2008 the inflation rate was recorded at 5.0%. 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.
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 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.
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