Deflation is spreading like the plague throughout Europe to the point where negative interest rates are in play. In the UK, inflation has cascaded to a 5 year low and is set to fall further as the early and encouraging signs of economic recovery in the first half of 2014 are snuffed out. Even in the US inflation is too low and this alone is seeing the market question just when the US Federal Reserve will start to hike interest rates from zero per cent.

This morning the oil price has crashed to below US$82 a barrel (WTI) as a ramp up in supply meets softening demand. The global indices of commodity prices are also plumbing fresh lows.

For Australia, this news is poison.

As an exporter of energy, the falling oil price is parlaying into coal and gas prices. The Australian economy, which is muddling along at best, it facing not just these specific commodity headwinds, but is getting a kick in the face from the broader deflationary global pressures.

At the same time, falling real wages are set to fall further. Pay rises in the public service and the defence force will be 1.5 per cent per annum, at best, and more likely will be around 1.2 per cent per annum for the next few years. The close correlation between public service wages and those of the private sector, means that aggregate wages growth and household incomes will be crunched lower from what is already a record low pace of wages growth at around 2.5 per cent.

Falling real wages will knee-cap the retail sector and consumer demand more broadly. Real GDP growth cannot get near 3.25 per cent if this is the case and the unemployment rate is set to rise further. Soon there will be talk of unemployment reaching 7 per cent. The risk is that Australia’s inflation rate will fall to, or even below, the bottom of the RBA target band.

The budget will be shot to pieces as revenue from PAYG income tax, capital gains and company profits gets mauled.

The RBA, currently with its ‘house price blinkers’ on, will need to dust off its obsolete forecasts and cut interest rates. It is always difficult to be sure how much more interest rate relief will be needed in the year ahead, but given the malaise creeping into business confidence, rising unemployment and a still high Aussie dollar, a cash rate of 1.5 per cent, or so, seems fair in the year ahead.

The economy needs this monetary stimulus if the unemployment rate is to be capped at 6.25 per cent, let alone fall back to 5 per cent which of course, is the main aim of macroeconomic policy.