RDP 2001-02: Changes in the Determinants of Inflation in Australia 1. Introduction

Low and stable inflation has been a feature of the Australian economy for the past decade. Australia's previous history of higher and more variable inflation encouraged many to discount the low inflation of the early 1990s as cyclical, even accidental.[1] As it turned out, low inflation has been maintained through a lengthy economic expansion and in the presence of various inflationary shocks. While a regime of inflation targeting has played a role in facilitating this outcome, inflation has been generally lower than expected, and certainly more stable. Concomitantly, inflation has been surprisingly subdued in a range of industrialised economies, including those without explicit inflation targets. A key question is whether these developments reflect a series of favourable shocks to prices or a more fundamental change in the inflation process.

It has been suggested that a more fundamental change in the inflation process might have occurred.[2] This view has gained currency because some types of shocks that previously had a conspicuous influence on inflation now appear to have much less influence. In the Australian case, this is best highlighted by the apparent change in the pass-through of exchange rate movements to final domestic prices. Since Australia is a small open economy, episodes of currency depreciation have usually generated an increase in inflation. But on two occasions during the 1990s, despite a sharp depreciation of the Australian dollar, and rising import prices ‘at the docks’, growth in final retail import prices remained subdued so that there was little effect on consumer price inflation.

The apparent reduction in exchange rate pass-through provides an example of a direct and visible change in pricing behaviour that has had a bearing on our recent inflation performance. However, other developments in the economy, that have less direct or visible consequences for prices, have also been at work. Over the past two decades in Australia, there has been a gradual but expansive program of market liberalisation that extends from financial and product markets to labour markets. This has now manifested itself in a variety of ways. There has been an increase in domestic competition, a shift away from centralised wage setting towards a decentralised enterprise-based system, and an attendant rise in trend productivity growth. Each of these developments is conducive to achieving lower and more stable inflation, at least in the short to medium run, and may have reinforced the effects of reduced exchange rate pass-through.[3] Furthermore, these changes have occurred in an environment where financial markets demand disciplined behaviour of public policy-makers.

This paper seeks to establish if a fundamental change in the inflation process has occurred in Australia. This task is challenging. There are many interactions between microeconomic conditions and macroeconomic management that influence inflation performance, but which are difficult to separately identify. The strategy adopted in this paper is to define the problem quite narrowly. We consider the inflation process in the context of a mark-up model, in which the domestic price level is set as a mark-up on unit costs of production. We then attempt to identify whether there has been a measurable change in the relationship between inflation and its main explanators. In other words, we are seeking direct evidence of a change in the inflation process. We do not address the more difficult and important question of whether the change in the inflation environment has altered the propagation of shocks in the economy in a way that reinforces price stability.

The paper is organised as follows. First, we present trends in inflation outcomes and show that inflation in the 1990s has been unusually benign, but not dissimilar to that in other countries. Second, we explore developments in each of the key explanators of inflation, highlighting changes that are unusual or structural. Third, we seek to establish the importance of these changes by comparing the properties of a mark-up model of inflation estimated in different periods. In particular, we test whether the impulse to inflation from a given shock has changed through time. Finally, implications and conclusions are drawn.


Stevens (1999) provides an assessment of Australia's inflation experience over the 1990s. [1]

Bootle (1996) is a prominent example of this claim. [2]

In the long run, these developments are likely to lower the price level rather than the ongoing rate of inflation, which is determined by monetary policy. [3]