Like many countries, Australia and New Zealand have vanilla cookie-cutter monetary policies. We both have an independent central bank that has been given the standard inflation target of 2% or so (strictly 2% to 3% over the longer haul in Australia, and 1% to 3% in New Zealand but with a focus on staying near 2%).

Trouble is, while inflation is supposed to be 2%, it isn’t turning out that way. It’s been too low. Core inflation (inflation when you have stripped out temporary price fluctuations from volatile items such as food and petrol) has been stubbornly below 2% for years.

Failure to hit the target has had important effects. Both reserve banks have had to cut interest rates even further from already low levels. The Reserve Bank of New Zealand (RBNZ) went first (a 0.25% cut to 1.5% on 8 May) and the Reserve Bank of Australia (RBA) wasn’t far behind (cutting rates by 0.25% in both June and July to deliver a cash rate of 1%). The RBNZ cut again in August, slashing off 0.5% to make its cash rate 1%, the same as Australia's. 

With rates this low in what are reasonably decent economic times, many people are now worried that both banks won’t have any ammunition left to support their economies in worse times.

Figure 1. Core inflation in recent years (%)Sources: Australian Bureau of Statistics (‘all groups ex volatile items’ series); Stats NZ (‘all groups less food and vehicle fuels’ series). Click the image to enlarge.

Unemployment is down and so is inflation

Predictably, there have been criticisms of reserve bank bosses Glenn Stevens and Philip Lowe (in Australia) and Graeme Wheeler and Adrian Orr (in New Zealand) that “you’re doing it wrong”. But the reality is that their counterparts in the US, the eurozone, Japan and elsewhere in the developed world have had the same difficulty. It’s not some local bumbling; it’s global.

What’s happened is that the economies they’re trying to steer towards 2% inflation have stopped behaving like they used to. Economies, the conventional but now questionable story went, show higher inflation when the good times roll: producers meeting boom demand bid up the prices of their inputs, and employees can ask for raises in a strong labour market.

If the economy is doing well enough for unemployment to go below some threshold rate (the ‘NAIRU’ in the jargon – don’t ask), then inflation will start picking up. Get the economy hot enough and 2% inflation will be a doddle. This is the ‘Phillips curve’ (named, incidentally, after Kiwi economist William Phillips) at work – high unemployment, low inflation; low unemployment, high inflation.

Measuring that magic non-accelerating inflation rate of unemployment (NAIRU) was never entirely straightforward, but best guess was it used to be 5% to 5.5% or thereabouts. But (as at August 2019) Australia has an unemployment rate of 5.2% and nothing’s happened. New Zealand has 3.9%: still nothing. America’s down to 3.7%, but seeing core inflation about 1.6%. Japan is worse again: the unemployment rate is a negligible 2.3%, but core inflation is only 0.7%.

Reasons why inflation is stuck

The ground has evidently shifted under the central bankers’ feet. That old Phillips curve has changed shape or broken down, and nobody is sure why. It’s not for want of trying. There are possible explanations all over the place, but none yet crowned the winner. Here are my 3½ nominations for Best Supporting Theory.

The first is growing international linkages. It’s no longer a simple link between how hot your local economy is and your local inflation rate. There’s actually a huge global pool of spare capacity – in China, in particular. While your local market might be humming, any potential inflation-generating shortages at home can easily be supplied from overseas.

“While your local market might be humming, any potential inflation-generating shortages at home can easily be supplied from overseas.”

It’s global capacity pressure that matters, and there’s still a long way to go before China and India hit limits to growth. They have big reservoirs of unemployed and underemployed people still to empty. Low inflation could be with us for a long time if this view’s right.

The next explanation is sharply lower prices for all that e-commerce and internet stuff: what you get for your laptop or phone or internet dollar goes further every year. This falling cost of IT does have a direct effect in reducing the measured inflation rate, but it’s the indirect effects that are important. What chance, for example, does a hotel have these days of ramping up its room rates? Or a newspaper of jacking up the cost of advertising? Or a cinema of raising ticket prices? Half of five-eighths, as their price setting is disciplined by the online alternatives. If this explanation is also part of the mix, low inflation looks to be well embedded in coming years.

How expectations create reality

The third reason revolves around people’s expectations about what inflation is going to be. While the NAIRU model of inflation used to be front of mind when economists were wondering about what drives inflation, they also recognised that people’s expectations were part of the process. If, for example, every producer in the economy thought inflation was going to be 5%, they wouldn’t be reticent about raising their own prices by much the same. And the same goes for employees: they’d be looking for 5% increases just to keep their real purchasing power intact. Many fair-minded employers wouldn’t jib at paying it, either.

You can see how this could become a self-fulfilling process. Everyone thinks inflation will be 5%: lo and behold, their subsequent reactions bring it about.

But now let’s add a wrinkle. Suppose people’s expectations are backwards looking: people think inflation is going to be what it’s recently been. If for whatever reason – maybe those NAIRUs not working like they used to – inflation is unexpectedly low, then people think unexpectedly low inflation yesterday means low inflation tomorrow, too. And they react by moderating their behaviour to bring it about.

Again, if this is a strand in the story, it’s not going away in a hurry. It would need a burst of unexpectedly high inflation to get people revising their views, and we’re struggling to get inflation up in the first place. Central banks might try to urge people to look forwards rather than backwards, but changing how people form their ideas is a slow uphill job. Stubbornly low expectations might well be with us for some time.

The final half-reason is the global financial crisis (GFC). It’s a reasonable guess that people are still getting over it, and both businesses and households may be unusually risk averse. They may, understandably, be reluctant to push their luck with price increases or salary demands. If that’s an element in what’s going on, it likely won’t be long term: memories fade, and normal service eventually resumes.

Overall, though, the forces generating low inflation look well entrenched. Businesses may once have had the option of helping cash flow by getting out the rate card and adding 5%, but that looks off the table for the foreseeable future.

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