Our persistent inflation problem

From Challenger Chief Economist Dr Jonathan Kearns

The latest forecasts from the International Monetary Fund (IMF) expect Australian inflation will eventually return to the RBA’s target, but it will be a bumpy ride for the next few years. Inflation has fallen sharply with the introduction of the energy subsidies, but like the RBA, the IMF calculates that when the subsidies end, energy prices will jump leading to a spike in inflation to 3.6% at the end of 2025. The IMF publishes longer horizon forecasts than the RBA which show they believe the RBA is credible in keeping inflation at its target of 2.5%, once it eventually gets there in 2026.

The IMF forecasts show that inflation is more persistent in Australia than in other countries. With the exception of Japan, the IMF expects inflation to be back at the central bank’s target in the next couple of years. But Australia stands out for how much inflation is above target for the next two years.

Japan has had years of not being able to stimulate inflation. While the Bank of Japan will be celebrating having inflation near their 2% target, the IMF forecasts expect inflation will not settle at target as smoothly as in other countries.

The key driver of persistent inflation in Australia has been the balance of demand and supply for the economy as a whole. One way of representing this is an ‘output gap’ which measures GDP relative to ‘potential GDP’, or in other words, the amount the economy is producing relative to how much it could produce without generating more inflation. A positive output gap indicates that output is greater than potential output and so is inflationary.

The IMF estimates that in 2022 and 2023 the output gap was larger than it has been at any time since the RBA adopted inflation targeting in the early 1990s. That is why we now have a persistent inflation problem. The output gap is projected to decline sharply so that the economy will be in balance by the end of 2025. The closest comparable episode of excess demand to the current episode was 2000. Then the RBA increased the cash rate to 6.25% to bring inflation back to target. Policy this time has not been as tight, so while the increase in unemployment will be smaller, inflation has been higher and more persistent.