Yesterday’s CPI reading has wider implications than interest rates. Although I’m of the view that the spike will be temporary, the need to lower the dollar to rebalance the economy will keep pressure on tradable inflation so we’ve doubtless passed the nadir of our recent low inflation past.
But it is not the RBA’s problem. It is the government’s challenge.
The key to this point is to understand the basic adjustment that the Australian economy must undergo.
As China shifts to lower growth and/or a less commodity centric economy so too must Australia. The three previous drivers of Australian growth, that have supported economic out-performance for the past 15 years, are all hampered. Some growth can be expected from consumption but owing to an already debt-saturated household sector, that will not and should not be enough. Government spending and investment can contribute too but its balance sheet supports household debt so it must be kept relatively clean as well. The third stage of the mining boom – volume growth – will also contribute to growth but it will be more than offset by declining investment. That only leaves other tradable sectors to pick up the growth slack via investment and export income.
The challenge with this is the real effective exchange rate (REER), which is a calculation based upon the combined value of a nation’s currency and its goods and services (that is its inflation rate). It is still very elevated owing to the mining boom and the housing boom before it. Such booms inflate either the currency, the inflation rate, or both, depending upon factors such as labour market flexibility and currency convertibility. Either way, the end result is a loss of competitiveness in tradable sectors like manufacturing where we need to find our new growth driver.
During the 1970s commodity boom, the country had a fixed-rate currency so much of the inflation transpired in wages as the need for labour expanded beyond capacity.
In our recently ended and even larger commodities boom, the Reserve Bank of Australia (RBA) made a conscious decision to prevent a repeat of this wage inflation by instead raising interest rates and pushing the currency very high. The result was a shakeout in tradable sectors (those that export or compete with imports) which meant demand for labour demand fell in those areas and was soaked up by rapidly expanding mining. This was known as the “structural adjustment’.
The RBA largely succeeded in preventing a wage cost breakout (beyond a few narrow sectors) but the result has still been Dutch disease, with a three year recession in manufacturing and weakness in other tradable sectors including, to some extent, retail, via the internet.
After the 1970s Australian commodity boom, the challenge of improving competitiveness was addressed by a decade of public policy aimed at undoing the rampant wage inflation that had been unleashed. Successive wages “accords” between government and unions slowly deflated the input costs in production. Competitiveness was also restored through the float and subsequent falls in the Australian dollar. And via productivity oriented reform.
And this is where Australia’s restive inflation rate is Tony Abbott’s problem. If inflation proves enduring this year then the improvement in competitiveness that is arriving through the lower dollar may be lost as wages start to rise, chasing prices, and ensuring that the currency devaluation does not repair the real effective exchange rate. Yet the RBA will be unable to raise interest rates as it protects the lower dollar and over-leveraged households.
The government of the day will have to prevent any wage push inflation breakout by preparing the population for the shared sacrifices of falling standards of living (as prices rise and wages don’t). It will have to corral unions and wage claimants in a national interest project of improved competitiveness. It will have to work assiduously towards higher productivity growth as well. It has much work to do.
