Reserve Banks belief that the Australian economy is still capable of achieving growth in excess

of 3 per cent will be challenged if this weeks March quarter inflation report repeats the
unacceptably elevated level of the December quarter.
The underlying measures of price growth rose to 0.9 per cent in the December quarter which, if
sustained, would push inflation well over the top of the Reserve Banks 2 to 3 per cent band.
Governor Glenn Stevens has described this result as something of a puzzle, given that economic
growth is slow, business surveys show plenty of idle capacity and wage rises are the smallest seen in
the 15 years that the Australian Bureau of Statistics has been measuring them.
If you think about the general situation, 18 months of growth having been below trend, unemployment
having gone up and wages growth having slowed, that is not one that would obviously be associated
with a sustained rise in price pressure, he told the last parliamentary economics committee hearing.
Although it partly reflected the depreciation of the Australian dollar pushing up the cost of imports, this
did not explain why the prices of domestic goods and services were rising.
It could be that there was a higher than usual degree of noise in the data, which can occasionally
occur, owing to the difficulties of measurement or the timing of price changes, the banks last
Monetary Policy Statement said. This would imply the higher-than-expected inflation recorded in the
quarter will not persist. Alternatively, the stronger inflation outcome raises the possibility that there is
less spare capacity in the economy than previously thought, which would suggest that the outlook for
inflation would be somewhat higher than previously anticipated.
It is this second option that the bank will have to consider if the March quarter again produces a high
figure for core inflation.
An analysis by HSBCs chief economist Paul Bloxham earlier this year suggested that potential growth
had slowed from 3.5 per cent a decade ago to closer to 2.8 per cent. Labour force growth has been
weak, reflecting the ageing of the population, while productivity growth, which averaged 2.2 per cent
from 1991 to 2003, had since slowed to 0.5 per cent.
He argued the productivity slowdown reflected the lack of commitment to economic reform over the
past decade, which had left Australia with a more inflexible labour market, an inefficient tax system
and inadequate quality infrastructure. A fall in the -potential growth rate would both be consistent with
the rise in inflation and with the unemployment rate, which has been falling despite actual economic

William Du

growth appearing to be below its long-term trend at about 2.8 per cent.
Stevens told a parliamentary hearing that his belief that potential growth was still at, or just above, 3
per cent assumed labour force growth of 1.5 per cent and a recovery in productivity on which he
declared himself probably a bit of an optimist. The argument that productivity is set for an increase
is partly based on a view that those trade-exposed businesses which have survived the extended period
of high exchange rates have been forced to become much more efficient. The commissioning of
resource projects will also lift productivity, as at least some of the construction phase gets
misinterpreted by the
ABS as inputs going into the resources sector with no corresponding output. This is reversed when the
projects start up.
I am not drawing from this at this point a strong signal about potential growth. I would say still that
the potential growth rate of the economy is 3 per cent or a touch more, Stevens said.
Estimating an economys potential growth is a fraught exercise. It is not easy to get an accurate
assessment of the total capital employed in the economy and nor is there settled science around what
full employment is. Treasury has used an unemployment rate of 5 per cent, on the basis that when, as
in 2006-07, it drops much below that, inflation starts to rise.
An analysis by University of NSW professor James Morley, presented to a Bank of Internat-ional
Settlements conference this month, says the relationship between the output gap (how far current
growth is below potential growth) and inflation is not linear. In many countries, including Australia,
the US, Japan and Korea, it appears to take a very large shortfall in output in order to generate
disinflation, whereas output that is not far above the long-term average can produce a spike in inflation.
Morley says the unstable -nature of the relationship between the output gap and the level of inflation is
shown by the failure of inflation to fall, despite steep drops in production following the global financial
crisis. This was the key concern for the International Monetary Fund until 2012, however the picture
has now reversed, with its latest economic review worrying that inflation is falling despite economic
recovery having reduced the gap between current growth and the long-term potential.
Most market economists expect the March quarter inflation report, published this Wednesday, will
show a moderate rise of around 0.7 per cent for the key underlying figure. Business surveys are not
detecting any unusual inflationary pressure and the bottom-up analyses show that the seasonal
increases in the cost of health and education, along with higher petrol prices will be offset by falls in
clothing, household equipment and recreation. This would leave the stance of the Reserve Bank and
financial markets unchanged.
A repeat of the December quarters inflation result would cause markets to bring forward their
estimates of when the Reserve Bank will start lifting rates again into the second half of this year.
The Reserve Bank itself could still remain cautious. In 2006-07, it was misled by two consecutive
extremely low quarterly consumer price surveys into leaving interest rates low at a time when all the
other evidence about the lack of spare capacity and labour shortages was saying there was an
inflationary threat. By the time the June quarter 2007 survey showed inflation was soaring, it was hard
to control.
It would not want to be misled into shifting prematurely to a tightening bias.

William Du

Analysis
The article reports that prices have grown by 0.9% at the end of 2013 and the
graph shows trends that inflation has been rising since early 2013. With
projections that inflation will continue to increase, even stated in the article as
possible to exceed the RBA target of between 2-3%, the Australian economy will
be affected in a variety of ways.
Inflation has the potential to reduce the real incomes of consumers, increase the
costs of production for firms and increase interest rates for governments having
to address reduced international competitiveness. As consumers who are often
paid a fixed salary or wage experience rising prices, the income they receive can
no longer be consumed for the same amount of goods and services. Hence, this
can lead to workers urging for increased wages, furthering the costs of
production for firms that are already burdened by increased prices. In an
attempt to reduce the prices and inflation, governments will apply
contractionary policy to decrease spending. This may include increasing interest
rates through the RBA.
Over the years, the RBA has set the inflation target between 2-3% over the
course of economic cycle and this target has mostly been achieved. This has been
through the RBAs management of monetary policy in adjusting the cash rate
through buying and selling Government securities. In turn, this affects the supply
and demand of funds in the economy and this will have a flow on effect upon
interest rates. This will affect the saving and spending patterns of consumers and
increase or decrease aggregate demand and regulate inflation. Over the years,
inflation has also been kept within the 2-3% range due to the increased
productivity of workers since the 1990s. However as reported in the article,
productivity growth has slowed down to 0.5%. This could contribute to the
increased inflation, attributed also by the lack of commitment to economic
reform over the past decadea more inflexible labour market, an inefficient tax
system and inadequate quality infrastructure.
However, with only predictions indicating that inflation will increase in the
future, the RBA has maintained their neutral stance on current inflation. The CPI
has indicated that increases in some goods and services have been offset by
goods and services in other areas.
This raises the concern whether inflation will actually exceed expectations and
whether the RBA should really intervene. The article has given past examples of
the RBAs failure to foresee rapid rises in inflation. This raises a dilemma as if the
RBA intervenes by increasing short-term interest rates, which increases the cost
of borrowing and effectively reduces its attractiveness. Severe or unnecessary
tightening of the economic market can result in deflation. Deflation occurs when
consumers do not have enough money to purchase economic resources, which
lowers prices and may result in extreme layoffs or bankruptcies from the lack of
business profit. Tightening the monetary policy unnecessarily will also decrease
potential economic growth.

William Du

Nevertheless with expect rises in inflation, this gives rise for inflationary
expectations. As people believe inflation will rise, this will affect the behanviour of
individuals and businesses to protect themselves. For example, consumers will
purchase more now, leading to demand inflation.

Price
Level
P2

AS

P1

AD
q1

q2

AD1

GDP / Y

Shown in diagram above, as aggregate demand increases, shifting to the right from
AD to AD1, the price level increases from P1 to P2. This shows inflation is caused.
Also if workers expect higher inflation they will demand wage rises. This causes
cost-pull inflation. According to the above graph, the AS will shift to the left. This
will cause a rise in prices.
Furthermore, the article also states that the depreciation of the Australian dollar is
pushing up the cost of imports. Inflation hence could be caused by domestic goods
increasing in price to match the price levels of imported goods. This will also cause
inflation.

William Du