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  • Pete Jonson

Sunday Sanity Break, 20 October 2019 - Two types of inflation confound RBA

Updated: May 1, 2020

The highly professional and detailed monthly RBA report is designed to demonstrate that no stone has been left unturned. However, there is at least one appararently small stone that demonstrates that there is a large rock left unturned. The apparent small stone is this: ‘Members noted that the ongoing subdued growth in wages implied that there continued to be spare capacity in the labour market.’

Today we all need to stretch our minds just a bit, so please focus, gentle readers.

To be sure there is almost certainly spare capacity in the Australian economy and indeed in global labor markets. But that is far from the end of the story. As I have argued elsewhere Paul Volcker’s big hit against US inflation in the US economy in 1980 and 1980/81 fixed US goods and services inflation. US asset inflation rose in fits and starts while goods and services inflation remained low, reminding me of the roaring twenties in America. And modern monetary policy workers have yet to resolve the causes of asset inflation.

Self portrait with model of consumer inflation (red) and asset inflation (blue), 2014.

In other countries goods and services inflation took longer to fix. But despite floating exchange rates low US inflation leaked into other economies. In Australia leaking low inflation was working slowly in the 1980s but very low goods and services inflation was only created in the accidental severe recession in 1990/91.

Congratulations to Deputy Governor Ian Macfarlane for apologising, but not for lack of RBA research. Workers got the message that life was tough and outlandish wage demands became a thing of the past. Then the global crisis of 2007/08 gave workers in most of the globe another great shock, reinforcing the sense in resisting the old game of demanding large wage increases. The reinforced prudence became the global norm. It is still a powerful force for low goods and services inflation.

Furthermore, even the excess money created by very low interest rates and devices like ‘Quantitative easing’ does little to boost workers’ wage demands. Low wages growth translations into low goods and services inflation. The state of mind of most global workers is ‘low Animal Spirits’.

With my colleague Clifford Wymer I have devised a way to embed hypotheses about the causes of Animal spirits of investors and speculators into a long-term model of the British economy. The wages equation contains the usual labor costs and inflation effects, and the goods and services inflation equation contains a measure of excess money


Yet excess money must go somewhere. Asset inflation is an obvious place for it to go. Investors and speculators in an environment of excess money and low workers Animal Spirits will cheerfully experience rising Asset inflation. Animal Spirits of investors and speculators are boosted, creating further rises in Asset Inflation. Asset inflation, whilst rising in fits and starts, often goes up a long way with occasional drops until the big drop comes. Strong Animal spirits eventually become weak or even terrified is determined in our model by the steady hand of the Bank of England, and the downward direction builds upon itself.

The UK share price equation contains the excess money effect and also a measure of Animal Spirits of investors and speculators. The relevant parameters are all significant and the coefficient on excess money in the goods and services equation is much smaller (0.131) than that in the share price equation (1.533). And there is the additional impact of Animal Spirits of investors and speculators in the Asset (share price) equation. This is a first run at explaining why goods and services inflation can be low while asset inflation is strong. The main implication is that central banks need a way to at least moderate Animal Spirits of investors and speculators. Go for it Philip Lowe.


Fiona Prior visits the White Rabbit Gallery to celebrate the first ten years of Judith Neilson opening her private collection to the public. This exhibition of contemporary Chinese art will leave you speechless. More here.

Image: ‘Chinese Offspring’ (partial depiction of installation) by Zhang Dali, courtesy of the artist and White Rabbit Gallery

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