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Why is Australia’s inflation rate so stunningly low?

Australia’s inflation rate is stunningly low. At just 1.0 per cent in annual terms, it is well below the bottom of the RBA target band of 2 to 3 per cent and it is low for reasons that are not all that favourable. In simple terms, the economy is too weak and the unemployment rate is too high.

There is a simple and well established link between the strength of an economy and the rate of inflation. It suggests that when an economy is strong with people spending at a rapid pace, businesses ramping up their investment and the unemployment rate falling, inflation is high or rising.

It is high because in these sorts of strong and optimistic economic times, businesses feel that they can edge up their selling prices without driving away customers. This is, by definition, inflation. The optimistic customers are willing to pay the higher prices because their financial circumstances are favourable.

What usually happens in these circumstances is interest rates go up. In lifting interest rates, the Reserve Bank wants to discourage borrowings and encourage savings and those people with debt will have to allocate more of their otherwise disposable cash to pay interest on that debt. This means they have less spare cash for elsewhere in the economy and as a result, the economy slows and with a lag, inflation falls back.

Now in Australia, inflation is very low and it is not hard to work out why.

The growth rate in the domestic economy is weak. Consumer spending is only a little above income growth and business investment is still in free-fall. Housing construction is one area of strength, but there are signs that new activity is topping out and the prior construction boom will leave a glut of property when the building that are currently half built are completed.

Amid this, the labour market is fragile. The bulk of the still modest increase in employment in recent months has been heavily skewed to part time workers which means that household income growth is subdued. Part timers take home less cash than full timers. A lot of workers want to work more hours but because of the soft economy, employers can’t give them the extra job opportunities. Even though it is off its peak, the unemployment rate remains stubbornly high at around 5.75 per cent.

Which come to the monetary policy implications of today’s CPI.

The RBA will look at the inflation result with some trepidation. It has missed its target for seven straight quarters and there is no evidence in any economic data that inflation will quickly pick up to get back within the target range.

Hence, the case for a further interest rate cut next week is strong. The official cash rate is set to fall to a fresh record low of just 1.5 per cent as the RBA does its bit to underpin a stronger pace of economic growth and with that, spark an uptick in inflation. Whether there are more rate cuts after that will depend on the growth and inflation performance in the months ahead. If the economy remains soft and unemployment ticks higher, inflation will remain too low and the RBA will be obliged to cut interest rates towards 1 per cent.