RDP 9105: Inflation in Australia: Causes, Inertia and Policy 6. Policy Implications

We see two policy implications from the results of this paper. The first is that the inertia in Australia's inflation rate implies that policy action which seeks a reduction in inflation will produce the desired result only after a substantial period of time. The second is that nominal wage growth is the principal determinant of price inflation in Australia. This poses a dilemma for policy makers. The deregulation of the labour market, with wages determined (perhaps) on an enterprise by enterprise basis, should facilitate efficiency-enhancing movements in relative wage levels. However, wages policy, as such, will then cease to exist as an instrument for combating inflation.

We could appeal to the Lucas critique (Lucas 1976) and assert that such a major policy change will fundamentally alter the structure of the economy, rendering obsolete both our estimated relationships and the need for a wages policy. However, this remains very much to be seen. In any case, the demise of wages policy implies that the entire burden of keeping the rate of price inflation acceptably low will fall to monetary policy, whose role shall then be to deliver the correct anti-inflation signals to price and wage setters. This will be a difficult assignment in an economy where goods and factor markets work only imperfectly, where wage levels are set as the result of bargaining outcomes, and where prices are set as markups over costs.