Over the past few years the narrative amongst most economists, which remains the general consensus to this day, has been that the RBA got ‘head-faked’ by a brace of low inflation prints in December 2006 and March 2007, which led them to delay future rate hikes. These inflation outcomes were almost exactly the same size—0.5 and 0.6 per cent, respectively—as the results in the second and third quarters of 2010.
The argument then goes that the RBA was forced to play catch-up in 2007 and 2008 as domestic inflation spiked to extremely high levels of up to five per cent (in September 2009), which has cast a question over the inflation-targeting performance of the Stevens RBA.
On this latter subject, headline inflation has averaged three per cent since September 2006 (when Glenn Stevens was first appointed), which is at the top of the RBA’s target band. Macquarie’s Brian Redican highlights that using a through-the-cycle average rate of inflation is not, however, a fair benchmark. In particular, he quotes the RBA’s Guy Debelle, who argues, “the intent is that over the course of the business cycle, the bulk of the distribution of year-ended inflation outcomes should lie between 2 and 3 per cent, not that the annualised average inflation rate from the start of the business cycle to the end should necessarily lie between 2 and 3.”
To meet Debelle’s standard, one should, therefore, use a median as opposed to average estimate on inflation. Since September 2006, median year-ended inflation has been 2.9 per cent while median ‘core’ inflation has been about 3.4 per cent. On any measure, the RBA’s recent inflation-targeting performance has not been great.
Johnson’s contribution is that he assaults the prevailing view that the principal driver of domestic price pressures was Australia’s terms of trade boom and a fall in the unemployment rate to sub-5 per cent. Recall that in 2006-07 unemployment was at or below the all-important ‘full employment’, or ‘non-accelerating inflation’, rate of unemployment. This is the threshold beyond which any further declines in unemployment are thought to drive up labour costs and trigger price pressures.
The 2006-07 episode is relevant to the RBA’s deliberations because there are some commonalities with current circumstances: we are once again experiencing a terms of trade boom and strong employment growth (although the jury is out on whether the unemployment rate is actually declining, or whether it has stabilised around five per cent)
A further wrinkle here, which Johnson points out, is that the RBA recently released a research discussion paper that found that the single best predictor of changes in inflation over time was the domestic unemployment rate.
Johnson’s analysis turns some of this on its head by positing that Australian inflation is more a global, rather than local, phenomenon. More specifically, he argues that low unemployment and the first phase of the mining boom were not the principal explanations for the high inflation Australian experienced prior to the GFC. His thesis also fits with the intuition that as a small, open economy which is a price taker in global markets, Australian inflation is heavily influenced by the global ‘output gap’—that is, how global economic output stands relative to global capacity. On this basis, if global output is running above (below) capacity, local and offshore inflation will rise (fall).
Johnson’s work has crucial consequences for Australia’s inflation and interest rate outlook: if global growth is expected to be below capacity for the foreseeable future, and the inflationary pulse weak, Australia could be set to endure a period of relatively benign price pressures. This would in turn suggest that the RBA may not need to lift the cash rate another four times to 5.5 per cent, as is currently believed by most market economists.
In his first chart below, Johnson compares Australia’s inflation path (blue line) with that of the US (red line) and an average of Germany, Canada, New Zealand and the UK (green line). The substantial rise in inflation in 2007-08 was clearly a global experience, although it is true that the very low prints in 2006-07 were somewhat indigenous to Australia, and not fully explained by the offshore dynamics.
The next two charts are fascinating. Johnson constructs a model of Australian inflation that is based purely on inflation in the US, Germany, Canada, New Zealand and the UK. He fits this model using data between the period 1994 and 2000, and then employs that historical analysis to forecast (out-of-sample) future Australian inflation between 2000 and 2010. As you can see, this global model of Australian inflation does a very good job of predicting changes over time. And where the local outcomes do diverge from the model’s expectations, they are patently attributable to idiosyncratic events, such as the GST and Cyclone Larry.
Based on these insights, the RBA still arguably made a mistake in 2006, since predicted and realised inflation in 2007-08 was way above target even when relying only on overseas inflation data. Here Johnson also notes that, “our conclusion that the inflation spike probably had little to do with idiosyncratic domestic policy is not (presently) shared by the RBA. Their most recent work on inflation modelling squarely takes the blame for inflation problem. The upshot of their modelling exercise is that the RBA is responsible for the lion’s share of the 2007/8 inflation problem, as they allowed the unemployment rate to fall too low.”
One risk to Johnson’s thesis is that structural changes in the composition of global economic output, with an increasing share of output generated out of emerging economies like China, India and Brazil, will mean that domestic inflation may be less influenced by the spare capacity in the US, UK, Germany, Canada and New Zealand. There is also a risk that globally low interest rates will stoke secular inflation pressures.
Nonetheless, Johnson has made an important contribution to our thinking on interest rates. He concludes, “Most forecasters presently expect wide global output gaps to depress global inflation for some time. If this is the case, the foregoing suggests there is a nontrivial probability that Australian inflation remains subdued, despite the capex/mining boom.”
