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A rising world inflation tide will submerge the Reserve Bank’s credibility

22 November 2021

3:59 PM

22 November 2021

3:59 PM

The credibility of the Reserve Bank of Australia has never been under greater threat in light of Governor Philip Lowe’s recent pronouncements that Australia will somehow escape the rising inflation tide overseas and that the official cash rate will accordingly stay pinned to 0.1 percent until 2024.  

It remains to be seen exactly how much inflation Australia experiences before 2024, but it is a huge call to say we will be insulated from inflation and interest rate developments abroad, especially in the US. 

These King Canute-like claims are at odds with two fundamental macroeconomic truths, both related to the fact that, economically speaking, Australia is not an island unto itself.   

The first truth is that inflation is not determined by domestic factors alone, most notably wages growth according to the RBA, but also by international forces.  In the past, trend changes in world inflation have broadly coincided with trend changes in Australia’s inflation rate.   

In other words, historically, Australia’s inflation has been imported in large part from abroad.  This is more likely than ever going forward because Australian goods and services markets have become more integrated with the rest of the world.   

The second truth is that domestic interest rates in an open economy like Australia are heavily influenced by global factors, so are never fully determined by the central bank.   

Due to international capital market integration, Australian interest rates have for a long time broadly followed trends in world interest rates which have been in decline since the 1980s as the last high inflationary wave spanning the 1970s and 1980s receded.   

In 1982 the yield on a ten-year government bond was over 16 percent, close to the corresponding US rate, but is now under 2 percent, again close to the US rate.   

The last high inflation episode also started as a supply side phenomenon due to massive OPEC oil price hikes.  High world inflation persisted at the time because compliant central banks accommodated the oil price shocks with expansionary monetary policy while governments boosted economic activity with loose fiscal policy.  

Similarly, recent sharp rises in energy prices, supply chain blockages and high shipping costs, hand in hand with money-financed fiscal excess, have set the global conditions for the latest incoming inflation tide. 

In the 1970s Australian governments tried to deflect blame for high inflation on the grounds that it was imported from abroad.  Yet today the RBA tells us this won’t happen.  However, it will, and how is through the prices of those goods and services set in the markets of our international trading partners.   

A theoretical macroeconomic model that explains how relatively small open economies import inflation is the so-called Scandinavian model of inflation which first surfaced in the 1970s.  It assumes small economies are ‘price takers’ unable to influence the prices of goods and services bought from and sold abroad.  

This is a useful first approximation in Australia’s case.  We cannot for instance influence the prices set in the US for motor vehicles, for TVs from Korea, or for whiskey from Scotland.  A variant of this model is known as the ‘dependent economy’ model, so named because many domestic prices, and hence inflation, depend on world prices. 

The approach also assumes the economy produces two classes of goods and services – tradables, or those goods and services that enter directly into international trade, and non-tradables, those goods and services, especially public and professional services, whose prices are set by demand and supply conditions domestically.   

The production of tradables presently accounts for over half of GDP and includes not only exports and imports, but also goods and services that compete with imports, like manufactured goods. If world export prices rise that also passes through to the prices of export goods consumed domestically.  For instance, if world wheat prices rise, so too will bakery items made locally.    

The only way prices paid for tradables domestically can differ from world prices is via movements in the exchange rate.  A depreciation will exacerbate tradables inflation, whereas an appreciation dampens it.   

Hence the reason why the Australian dollar during the 1970s and early 1980s (when it was pegged) was purposely overvalued at times by the RBA as an anti-inflation instrument.   

If the now floating Australian dollar remains as steady as it has been recently however, foreign price rises will pass through to tradables inflation.  However, if the US Federal Reserve raises US interest rates before 2024 and the RBA does not, the Australian dollar would depreciate, further worsening inflation here.  

So what does the recent data tell us about inflation from this perspective?  

The RBA publishes tradables versus non-tradables price rises as apart of its CPI series, with the latest data showing both rising above the 2-3 percent target band.  Tradables inflation averaged around 3.4 per cent over the June and September quarters, whereas non-tradables inflation rose 3.6 per cent.   

Rising world inflation will keep pushing tradables inflation higher whereas higher government spending, including on infrastructure, which falls predominantly on non-tradable goods and services, will feed non-tradables inflation. 

History suggests the inflationary tide will keep rising, despite RBA declarations to the contrary. 

Tony Makin is professor of economics at Griffith University 

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