Inflation in the December quarter surprised on the downside. Headline inflation was negative 0.1% for the quarter, or 3.3% for the year to December. This result was mainly due to big falls in the price of petrol, other fuels and fruit. So called “underlying” inflation was 0.5% for the quarter and 3.0% for the year to December. These numbers are down from the September quarter and also below the average economist’s prediction.

This gives Messrs Howard and Costello – and RBA governor Glenn Stevens – a huge free kick. Stevens will not feel compelled to hike interest rates, at least for the time being. His political masters will have a chance to maintain their reputations as superior economic managers and this would be likely to get them over the line in a tight election. (Henry’s views on national politics at this election are linked here.)

It is not generally realised that the new IR laws are helping to contain wage demands, and to a surprising extent. It is easier to fire people, which encourages employers to hire, but it also encourages employees not to be too demanding about pay and conditions. Members of the army of independent contractors are self-employed and will only raise their hourly rates if they are very confident they will keep working at those higher rates.

But there is a further point. Like many other countries, Australia has a lot of people on welfare, employed for fewer hours than they would like or totally discouraged and not even counted among the officially “unemployed”. At least some of these people, plus the army of independent contractors, provide a powerful if largely unnoticed buffer stock in the labour market. If the rate of unemployment really were as low as the official estimate of 4.6% of the workforce, wage push inflation would be a major concern to the Reserve Bank. As it is, the relatively low growth of labour costs is one force helping contain inflation.

The theory behind containing inflation is that it is the best contribution the Reserve can make to the achievement of full employment and general prosperity. Inflation and unemployment are also related in another sense – unemployment represents present misery, while inflation contributes to future misery, for example by raising interest rates. This line of thought led a prominent economist, Robert Barro, to devise what he called the “Misery index”.

Australia’s misery index since 1966 shows a massive spike created under the Whitlam government and a reduction since then in fits and starts. For the past decade, inflation has been creeping up (with the recent relief already acknowledged) while the overall misery index has continued to decline. The simple explanation for this is that the (official) rate of unemployment has declined faster than inflation has risen.

During the remainder of 2007, the Reserve Bank with be scanning the inflation numbers closely. It will also be carefully monitoring labour markets for signs of wage push inflation. The official rate of unemployment used in the misery index in the graph is at best a crude indicator, and we intend to refine this in future contributions. For the present, the current misery index is the best we have. Monitor this closely. If it starts to rise, especially if this is due to rising inflation, the RBA will have no choice but to raise interest rates again.

Read more at Henry Thornton.

Peter Fray

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