02 Feb, 2016 The key to Australia’s economic success: locking in low inflation
hen Paul Keating “snapped the inflation stick” in the early 1990s, he delivered one of the most valuable, potent and lasting reforms to the Australian economy. Sustained low inflation with a specific target was, in many ways, as important as the decision to float the Australian dollar.
Decades on from this economic fracture, Australia has one of the highest standards of living in the world and has not had a recession in a generation. Last week’s December quarter consumer price index confirmed annual inflation running at just 1.7%, meaning that, over the past 25 years, inflation has averaged 2.5%, which is in stark contrast with the 1970s and 1980s, when annual inflation averaged a destructive 9.2 per cent.
Low inflation is important for many reasons but the boost to living standards for low and middle-income earners is among the strongest.
When an economy can lock in low inflation over an extended time frame, as Australia has, it means that those who receive even modest increases in wages and pensions have the purchasing power of their incomes at least maintained, if not improved.
When Glenn Stevens releases his statement after the Reserve Bank of Australia’s monetary policy meeting on Tuesday, there is no prospect that he will say the inflation target is not being met. But if disinflation risks were to build, the RBA would cut interest rates. In an extreme case that deflation risks build even with interest rates cut to zero, the RBA has signalled that it would consider copying the US Federal Reserve and other central banks by embarking on quantitative easing or moving interest rates below zero.
Over the past 25 years, the average growth in wages, pensions and most welfare payments has been significantly higher than inflation. This means that the purchasing power of the household sector has increased, year in and year out, underpinning economic expansion.
For example, let’s say a person earns $100 and spends it on the goods and services they need and want. They have zero savings. With inflation at 2.5% and income growth of 3.5%, after one year the same goods and services will cost $102.50 but the person’s income will have risen to $103.50. This means they have an extra $1 to save for the future or spend now.
Over a decade the gains are even more pronounced with the price of goods increasing to $128, while the person’s income will have risen to over $141, meaning a life-changing 10% rise in purchasing power.
Low inflation has other benefits for the economy, most notably low interest rates.
For the business sector, the threshold for profitable investment is lowered, which benefits the economy and enhances capacity for productivity growth. Business will increasingly be focused on investment decisions that will add to profitability through innovation and efficiency rather than undertaking a speculative business expansion on the assumption that a high inflation rate would “pay off” the debt. This asset price inflation investment strategy was a problem that dogged Australian commercial property in the late 1980s and, in many ways, exacerbated the depths of the early 1990s recession.
Well run, prosperous and productive economies inevitably have low, relatively stable rates of inflation. Thanks to the structural lowering of inflation and the subsequent decision of Keating, the then treasurer, Ralph Willis, and the then RBA governor, Bernie Fraser, to target inflation, Australia has been a shining light of the global economy for many years.
It is a target that has been hit with freakish accuracy, especially given some of the big picture economic thrills and spills over that time.
Breaking the “stick” of inflation and locking in low inflation is an under-appreciated reform of the early 1990s that thankfully has bipartisan political support. Given the contribution low inflation has made to Australia’s economic wellbeing over that time, it is hopefully a target that is never altered.
And there is little or no doubt that over the next three or five or 10 years that inflation will average between 2% and 3% and Australia will be all the better for it.