You know the world's behaving strangely when you hear a heavy from the central bank saying it's expecting more "progress" on the "turnaround in inflation", then realise they're hoping inflation will go higher.
That's just what Dr Luci Ellis, the Reserve Bank's third heaviest heavy, told a bunch of economists at a conference this week.
Why would anyone hope for prices to be rising faster than they are? Not so much because higher prices are a good thing in themselves, as because rising inflation is usually a sign of an economy that's growing strongly and keeping unemployment low.
By contrast, very low inflation – say, below 2 per cent – is usually a sign of an economy that's not growing strongly, with unemployment either rising or higher than it should be.
Ellis' remarks are a reminder that the economy's biggest problem at present is weak growth in wages. She knows that if prices started rising faster, the most likely explanation would be higher growth in wages, which employers were passing on to their customers by raising their prices.
What could oblige employers to increase the wages they pay? Their need to retain or attract more workers – particularly skilled workers – at a time when the demand for labour was rising, caused typically by increased demand for the goods and services businesses were employing people to produce.
The point to note here is that the Reserve's mental model of inflation is of what economists used to call "demand-pull" inflation. It's simple: the prices of goods and services rise when the demand for them is outpacing their supply.
Note, too, that this involves an inverse relationship between inflation and unemployment: when one goes up, the other goes down, and vice versa. Economists call this the "Phillips curve", named after its discoverer, Bill Phillips, a Kiwi economist.
Ellis confirmed that, although the economy (real gross domestic product) grew at a trend rate of just 2.4 per cent over the year to September, the Reserve's forecast that growth will pick up to about 3¼ per cent over this year and next remains unchanged.
This will involve a pick-up in wage growth and inflation, she said.
The Reserve is more confident of these forecasts than it was when it first made them in early November. Even so, Ellis admitted to some particular "uncertainties": how much production capacity in the economy is going spare at present, and how much, and how quickly, wage growth and inflation will pick up as spare capacity declines.
How much unused production capacity remains in the economy matters because, until it's used up, the economy can grow much faster than it can once the economy's at full capacity – full employment of labour and capital – without this causing inflation pressure to build.
Once the economy is at full employment, how fast rising demand can cause the economy to grow without also causing higher inflation is determined by the economy's "potential" growth rate – that is, by the rate at which rising participation in the labour force, increasing investment in capital equipment and improving productivity are adding to the economy's ability to produce more goods and services.
That is, how fast potential supply is growing. So the economy's potential growth rate sets the medium-term speed limit on how fast demand can grow before causing a build-up in inflation.
The Reserve's most recent estimate is that our potential growth rate has slowed to 2.75 per cent a year (mainly because of the retirement of the bulge of baby boomers).
But how do we measure how much spare production capacity we have at any time? We measure the spare capacity of our mines, factories and offices mainly by looking at answers to questions in the regular surveys of business confidence.
That's physical capital. In the labour market, idle production capacity is measured by the rate of unemployment.
But it's wrong to think full employment is reached when the unemployment rate falls to zero. That's partly because, at any point in time, there will always be some workers moving between jobs (called "frictional" unemployment).
Also because of a much higher rate of "structural" unemployment. The structure of the economy is always changing, with some industries expanding and some contracting. This increases the number of workers who don't have the particular skills employers are seeking, or who do have them but live far away from where the job vacancies are.
In the old days, there were a lot of low-skilled jobs that could be filled by people who had left school early and hadn't learnt much. These days, there a far fewer of those jobs, so people with inadequate skills are often out of a job.
Economists measure full employment by estimating the rate to which unemployment can fall before shortages of skilled labour cause employers to bid up wages and thus cause price inflation to accelerate.
They call this the NAIRU – the non-accelerating-inflation rate of unemployment – and the Reserve's latest estimate is that it's "around 5 per cent". It says "around" because every economist's estimate is different, so it's wrong to be too dogmatic.
This week's trend figures from the Australian Bureau of Statistics for the labour force in January show the unemployment rate has been steady at 5.5 per cent since July. That's well above the NAIRU.
Over the same six months, however, employment has grown by almost 180,000, or 1.5 per cent, causing the rate at which people are participating in the labour force to rise by 0.4 points to 65.6 per cent – its highest for seven years and a record high for participation by women.
If the laws of supply and demand still hold – a safe bet – this unusually strong growth in the demand for labour should lead to higher wages and then higher prices sooner or later. But Ellis warns it's likely to be "quite gradual".
