October 24, 2019 by Dymphna

Understand the economy in under 5 mins.

This is how to think about our unusual economy.

Ok, I’m going to give you a handle on how the economy works, in under 5-minutes.

Once we’re done, you’ll have a better handle than most on how this crazy ol economy works, and you’ll know why the RBA is in such a pickle right now.

Alright. So the economy is complex. Economics as a discipline is just a cluster-fuddle of confusion. But we can go a long way with a few simple rules of thumbs.

Ok, so here’s the first rule of thumb:

The RBA will cut rates when it wants the economy to do better. It will raise rates when it wants to slow things down.

You can think about interest rates a bit like the brakes on a car. You let the brakes off when you’re happy for the car to run. You put the brakes on when you want to slow things down a bit.

(This actually points to one of the RBA’s challenges. Taking your foot off the brake doesn’t help you if the car has already stalled…)

Anyway, so the RBA is operating the brakes on our economy. But what is our ‘economy’. What does the RBA want when it wants ‘the economy’ to do better.

This brings us to our next rule of thumb.

The RBA wants everyone to have a job, and for inflation to be low, but not too low.

If everyone in Australia who wants a job has a job, and inflation is somewhere in the 2-3% target band, then it’s happy days at the RBA.

But that’s not often the case, and our two key measures tend to go in different directions. So if the economy slows, then inflation falls but unemployment rises.

And if the economy goes to fast, then unemployment falls but inflation rises.

So this gives us another rule of thumb:

“Managing the economy” is about managing the trade-off between unemployment and inflation.”

Obviously keeping things pretty simple here, but this rule of thumb will get you a long way in predicting interest rate movements.

Now, if you’re all still with me, this brings us to the pickle that RBA currently faces.

Right now, unemployment is low, and has been, more or less, trending lower since 2015.

And yet, the RBA is taking its foot off the brake. It’s cutting rates and cutting rates quite aggressively.

And that’s because the relationship between inflation and unemployment is breaking down.

Both unemployment and inflation have been trending lower at the same time. This is a bit unusual.

And the reason why that’s happening is because wages aren’t growing.

Wages are the link between unemployment and inflation. The rule of thumb is, or at least used to be:

When unemployment is low, wages go up, and that pushes up the price of everything (i.e inflation increases). When unemployment is high, the opposite happens. 

That rule of thumb worked well for a generation, but it’s not working now.

In fact, wages growth is so weak, that over the past five years we have had the lowest growth in disposable income in the OECD!!!

So this is the pickle the RBA is now in.

It now seems that no matter how low unemployment goes, we’re not going to see any increase in inflation.

So what do you do then? Our economic managers are all about “jobs and growth” but it now seems that no amount of jobs and no amount of growth are going to give us the inflation the RBA wants.

So what do we do?

This is where we entered uncharted territory a bit.

Some people are saying that the RBA should just stop caring about inflation. As long as everyone has a job, let inflation go as low as it wants. Who cares?

I’ve got some sympathy for that line of thought, but it would be a pretty radical change in direction for the RBA.

Whatever the case, with the link between unemployment and inflation broken, the RBA is free to cut as much as they want to try and drive inflation higher.

And that’s what we’re seeing. Aggressive rate cuts, even though unemployment is low.

And even though unemployment is low, there’s no reason not to cut rates again.