Reserve Bank governor Philip Lowe started his study of economics at high school in Wagga Wagga and finished it with a PhD from the Massachusetts Institute of Technology. Much thanks to his teacher, Mrs King, whose teaching style convinced him economics was interesting as well as important.
The great attraction of high school economics is its emphasis on linking theory to current events.
According to a speech he gave last week, when Lowe did the HSC in 1979, the standard exam question was: why does Australia have both high inflation and high unemployment ("stagflation") and what’s the government doing about it?
In those days there was much interest in the "misery index", which adds the inflation rate to the unemployment rate. We got to peaks well above 20 per cent. Today, however, it’s below 7 per cent.
As the Australian Bureau of Statistics advised this week, the consumer price index rose by just 1.6 per cent over the year to June. Which means it’s been below the Reserve’s inflation target of "between 2 and 3 per cent, on average, over the medium term" for almost five years.
So Lowe’s guess is that, these days, exam questions are likely to ask: why is inflation so low at the same time as unemployment is also low – and what’s the government doing about it?
Just to be of help, he told us how he’d answer the question – which is one of interest and importance to all of us, not just youngsters preparing for their finals.
He started by noting that very low inflation has become the norm in most economies. At present, three-quarters of advanced economies have an inflation rate below 2 per cent.
There’s no single answer, he says, but there are three factors that, together, help explain what’s happened.
First, the credibility of the monetary "frameworks" that central banks eventually adopted when, in the second half of the 1970s, they realised inflation was way too high and needed to be got under control.
It wasn’t until the early '90s that our Reserve Bank adopted its present target for inflation which, as Lowe says, helped cement low inflation “norms” in the economy. In econospeak, it provided an anchor for business and unions’ expectations about how much prices were likely to rise over the next year or two.
"Many people understand that if inflation were to pick up too much, the central bank would respond to make sure the pick-up was only temporary,” Lowe says.
It would do so by raising interest rates and so discouraging borrowing and spending, of course. Economists call this the "monetary policy reaction function".
(It’s one of the reasons for the old view among economists that attempts to use the budget to stimulate demand by cutting taxes or increasing government spending wouldn’t achieve much. The central bank, fearing the stimulus would push up inflation, would react by raising interest rates and so stymie it. In the new world of continuing weak demand and too-low inflation, however, central banks are most unlikely to react to budgetary stimulus in such a way, meaning the new view is that budgetary stimulus is very effective.)
Has inflation targeting worked? Well, annual inflation has averaged 2.4 per cent since the target was adopted, so it certainly seems to have.
The second part of Lowe’s explanation for very low inflation is that spare capacity to produce goods and services (including spare workers who are unemployed or under-employed) in many advanced economies means there’s little upward pressure on prices.
That certainly seems the case in Australia. Our unemployment rate could go a lot lower than its present 5.2 per cent without causing wages to take off – especially with our under-employment rate of 8.3 per cent.
Our labour market seems to be more flexible – and less inflation-prone - than it used to be.
The third part of his explanation is that changes in the structure of the economy caused by technology and globalisation seem to be keeping prices low.
For one thing, digitisation and globalisation seem to be lowering the cost of producing many goods. The entry of China and other emerging economies into the global trading system has added hundreds of millions of factory workers to the global market.
The prices of manufactured goods in the advanced economies have barely increased over the past couple of decades.
For another thing, globalisation and advances in technology are making markets more contestable and increasing competition. This is extending beyond manufacturing to almost every corner of the economy, including the services sector.
Historically, most services couldn’t be traded across national borders. But globalisation – driven mainly by advances in information and communication technology – means many services can now be delivered by somebody in another country.
Examples include preparation of architectural drawings, document design and publishing, and customer service roles (a nice name for call centres). As well, many tasks such as accounting and payroll have been automated.
The internet and its digital “platforms” have revolutionised services such as retail, media and entertainment, and transformed how we communicate, and search for information and compare prices.
"These changes are having a material effect on pricing, with services price inflation lower than it once was. Many firms know that if they don’t keep their prices down, another firm somewhere in the world might undercut them," Lowe says.
"And many workers are concerned that if the cost of employing them is too high, relative to their productivity [an important qualification], their employer might look overseas or consider automation."
More broadly, using the internet for better “price discovery” keeps the competitive pressure on firms.
The end result is a pervasive feeling of more competition. And more competition normally means lower prices.
What’s the government doing about low inflation and the deficient demand that is part of its cause?
Well, if you mean the elected government, the short answer is: not nearly enough. Especially when you remember how little scope the Reserve Bank has left to cut interest rates.
