'New normal' could be dangerously close to deflation.

Remember inflation?

The Reserve Bank estimates the annual inflation rate right now is zero. Zip, zilch, nada, none.

That is consumer price inflation, of course. House price inflation is a different story.

But the bank's price stability mandate is defined in terms of the consumers price index. It is to keep "future CPI inflation outcomes between 1 and 3 per cent on average over the medium-term, with a focus on keeping future average inflation near the 2 per cent target midpoint".


The bank forecasts inflation to gradually rise back towards 2 per cent over next the two years (1.7 per cent, to be precise). That is another way of saying, given the lags with which monetary policy work, that it thinks its current official cash rate setting is right.

If it is correct, for a change, it will still make five straight years with inflation below the 2 per cent target, in fact averaging 1 per cent.

So is that a bad thing? Does it indicate monetary policy has been too tight?

Are we seeing a structural shift in the relationship between growth and inflation which the Reserve Bank's economic modelling has yet to capture?

Whether very low inflation is a good or bad thing depends on why it is happening.

If it reflects a weak economy where no one dares raise their prices then it is bad. That was arguably the position during what was the deepest recession since the 1970s, followed by a particularly slow recovery.

But it is hardly the position now when the economy is growing at an annual rate of 3.3 per cent.

Rather, it reflects the fact that excess capacity in the world economy means there is little global inflation to import, oil prices have fallen sharply and record net immigration is keeping a lid on wage inflation.


It might be optimistic to assume oil prices are going to fall much further; if they do not, then the falls which have already occurred will drop out of the inflation rate within a year or so.

Similarly, we had better hope, given the depth of the relationship, that the current weakness in the Australian economy driving the current strength of net immigration is a transitory thing.

Excluding petrol prices, the Reserve Bank forecasts annual inflation in the current March quarter would be 0.9 per cent.

But it also forecasts economic growth over the next couple of years to run at a rate somewhat faster than what it reckons is the potential (or sustainable non-inflationary) rate, based on such things as growth in the labour force and productivity.

That implies inflation will gradually pick up towards the targeted 2 per cent rate.

"That will take time," the bank's chief economist John McDermott said last Thursday, "but it is probably appropriate it takes that time."

Forcing the pace by a heavy-footed approach that would see the bank hit the accelerator now, only to hit the brakes sooner and harder down the track, would be inconsistent with another clause in its mandate, to avoid unnecessary instability in interest rates and the economy.

The risk in this approach lies in inflation expectations.

If an extended period of inflation wobbling around a trend line of 1 per cent comes to be seen as the new normal and becomes entrenched in wage- and price-setting behaviour, that could be a problem because it is too close for comfort to the quicksand of deflation.

If people come to expect that the price level will fall they are more likely to defer purchases, which is bad for business and employment. And negative inflation can mean real interest rates are too high and increase the real burden of debt. It is very hard to get free of, as the Japanese can attest.

Without using the D-word, Governor Graeme Wheeler was at pains last week to stress that his target is 2 per cent inflation, not 1 per cent, and that the bank is wary of inflation expectations continuing to fall as a result of low reported headline inflation.

The risk is that where expectations go, actual wage- and price-setting follow. In the 2000s annual inflation was about 2.5 per cent on average and inflation expectations settled there over time.

"Recently headline inflation has been more subdued and inflation expectations have moderated towards the 2 per cent target midpoint," the bank said in its March monetary policy statement.


From the bank's point of view that is fine, but if expectations were to settle near 1 per cent and that flowed through to wages and other prices, then it would respond by cutting interest rates, by 50 basis points or so.

But what if there is more to the prevailing low inflation than a series of shocks -- the GFC, migration, oil?

What if there is an underlying structural change which has altered traditional relationships between the big economic variables?

What if the potential growth rate is higher, and the neutral interest rate (which maximises employment without unleashing inflation) is lower than the bank has assumed?

To be fair, the bank has revised down its estimate of a neutral interest rate from around 6 per cent before the GFC to 4.5 per cent. So it sees an official cash rate of 3.5 per cent as stimulatory.

However, it remains an open question, it says, whether that adjustment was sufficient.

The twin influences of ever-deepening globalisation and the ever more inventive harnessing of digital technology are challenging how mathematical models of economies are calibrated.

"All models are wrong," McDermott said. "Clearly the [inflation] outcomes have come in lower than we forecast. That would be true of anyone in the market."

The important thing is to learn from those forecast errors.

The danger is learning more than they have to teach. As the saying goes, the four most expensive words in the language are "this time is different".

"Right now the focus is on oil prices and, provided that does not have an undue influence on price-setting behaviour, [inflation] will steadily come back to 2 per cent,' McDermott said.

"But there is no guarantee here, and we have to be vigilant."

Illustration: Anna Crichton.