Inflation is quiescent. Australia’s quarterly rate of consumer price inflation was flat at zero in the March quarter of this year while the annual rate fell to 1.3 per cent. Those were the weakest outcomes since March and June 2016, respectively. Measures of underlying or core inflation were similarly subdued, with the trimmed mean recording a 1.6 per cent increase over the year and the weighted median up just 1.2 per cent over the same period. With a couple of exceptions (March 2017 and June 2018), headline inflation has been stuck below the bottom of the RBA’s target band since December 2014 — for all but two of the past 18 quarters.
In 2014, economists at the International Monetary Fund coined the term “lowflation” to describe the phenomenon of ultra-low inflation in the euro area. Subsequently, the term has been used to refer to the more general inability of many of the developed world’s central banks to deliver an inflation rate as high as mandated by their targets. Australia is currently a member of this lowflation club.
Why is Australian inflation so low? Mechanically, the low rate of price increases in the March quarter was the product of developments across several key components of the consumer price index (CPI). For example, low oil prices at the start of the year helped to push down the headline rate (although they are likely to have pushed it up again in the June quarter). Housing market weakness has also worked to limit overall price rises — the two largest components of the CPI basket are rents and new dwelling purchases by owner-occupiers, which together account for about one-sixth of the basket. And inflation in so-called administered prices has also slowed notably over the past year as policymakers have actively targeted cost-of-living pressures.
Another way to think about lowflation is in terms of economic models of the inflation process. One of the most influential of these has been the Phillips curve, based on the idea of an inverse relationship between inflation and measures of slack or spare capacity in the domestic economy, typically the unemployment rate. The theory is that low levels of unemployment trigger faster rates of wage growth, which, in turn, push up costs and therefore prices, and vice versa.
However, in recent years, wage rises — and any associated inflationary pressures — have been surprisingly weak given the prevailing unemployment rate, at least based on past experience. Possible explanations include the claim that underemployment is now a more important indicator of true labour market slack than unemployment; and the suggestion there has been a fundamental change in the relationship between unemployment and wage growth (sometimes described in terms of a combined flattening of, and downward movement in, the Phillips curve).
Theories about shifts in the Phillips curve often focus on a possible decline in workers’ bargaining power over wages due to some combination of technological innovation including automation, competitive pressures from globalisation and changes in domestic labour market institutions.
The prevalence of lowflation across a range of developed economies suggests there are also likely to be common international factors at work. Once again, favoured candidates include some combination of the impact of globalisation, automation and institutional change, both on labour markets and on the price-setting activities of firms, while other theories posit that inflation-targeting central banks such as the Reserve Bank of Australia (RBA) have been too successful in changing inflation expectations, convincing the public that inflation will be permanently lower.
There is also empirical evidence that inflation has become increasingly synchronised across the world economy: according to one estimate, for example, the contribution of a global factor to inflation across developed economies has almost doubled since 2001, rising to account for about 25 per cent of the variation in inflation across countries.
All that said, while the recent global experience has been one of general disinflation (with some notable exceptions such as Venezuela), history reminds us we’ve experienced prolonged periods of low inflation in the past, which have then been followed by inflationary breakouts and economic regime changes. Granted, it’s difficult to see any such regime shift in the near term, but trends such as rising protectionism and the dramatic growth in global debt may yet turn out to have implications for the longevity of the current global economic regime.
In the longer term, persistent lowflation seems likely to fuel a debate over the monetary policy framework, both in Australia and overseas.
Lowflation meets monetary policy
What are the implications of lowflation for monetary policy? In the short term, the RBA cut interest rates to an all-time low of 1.25 per cent in June, its first rate change since August 2016. Financial markets had already fully priced in the expected 0.25 percentage point cut and responded favourably to the decision. RBA governor Philip Lowe warned big banks that failing to pass on all of its official rate cut risked undermining the economy as he paved the way for further reductions in a bid to slash Australia’s jobless rate. Major lenders responded by cutting rates on housing finance.
In the longer term, persistent lowflation seems likely to fuel a debate over the monetary policy framework, both in Australia and overseas. Such a debate is already underway, although it remains some distance from consensus. Instead, economists have been living up to the cliché of offering diametrically opposed advice, some advocating central banks increase their inflation targets as a way of lifting inflationary expectations even as others have argued they should cut them to better recognise the realities of a low-inflation world.
Others have made the case for junking the inflation targeting approach altogether and replacing it with some form of nominal income targeting, effectively triggering another economic policy regime shift. The longer inflation remains below central banks’ targets, the more heated this debate is likely to become.