RDP 9510: Modelling Inflation in Australia 8. Conclusions

The error correction model in (17) has sensible economic and statistical properties, and it contains “value added” relative to existing models of Australian inflation. While it remains to be seen how the ECM will perform in the face of additional changes to the economy, continued low inflation through the 1990s appears to turn on sustained low growth rates in unit labour costs and import prices.

Justification for such inferences is founded on two counts. First, the estimated ECM is remarkably stable across a wide range of economic changes in the 1980s and 1990s. The coefficients are well-defined and do not alter significantly over this period. Second, many of the major economic changes that have occurred or are occurring should have their effect on the right-hand side variables themselves, and so need not imply any change in the coefficients of the CPI equation. For example, increased productivity and greater pressures on wage setters to remain internationally competitive may imply a lower outcome for unit labour costs rather than any change in the relationship between unit labour costs and consumer price inflation. Similarly, changes in tariffs may affect inflation through only the tariff-adjusted import price series.

Equation (17) does not capture some changes, which may bias inflation forecasts upwards. For example, increased competition due to internationalization may reduce the ability of domestic producers and retailers to widen their margins as the economy picks up, so the model may overstate the inflationary impact of the narrowing of the output gap. That said, such changes have been ongoing in the past decade, but appear to have had little effect on the coefficients in (17).