How inflation became a big problem, but has disappeared

Treasury Secretary Dr Steven Kennedy observed this week that there’s been “a fundamental shift in the macro-economic underpinnings of the global and domestic economies, the cause of which is still not fully understood”. He’s right. And he’s the first of our top econocrats to say it. But he didn’t elaborate.

This week we got further evidence of that fundamental shift. The Australian Bureau of Statistics’ consumer price index for the September quarter showed an annual “headline” inflation rate of 0.7 per cent and an “underlying” (that is, more reliable) rate of 1.2 per cent.

This is exceptionally low and is clearly affected by the coronacession, as you’d expect. But there’s more going on than just a recession. Since 1993, our inflation target has been for annual inflation to average 2 to 3 per cent. For the six years before the virus, however, it averaged 1.6 per cent. And most other rich countries have also been undershooting their targets.

So, part of the “fundamental shift” in the factors underpinning the global economy is that inflation has gone away as a significant problem. But why? As Kennedy says, these things are “still not fully understood”. Some economists are advancing explanatory theories, which the other economists are debating.

Former Reserve Bank governor Ian Macfarlane, who has form for being the first to spot what’s happening, offered his own explanation of the rise and fall of inflation in a recent Jolly Swagman podcast.

Macfarlane says that, though every developed economy’s experience is different, they’re all quite similar. If you stand well back and look at the rich countries’ experience over the past 60 years, he says it’s not too great a simplification to say that two phases stand out: inflation rose in the first phase to reach a peak in the mid-1970s to early 1980s, but then fell almost continuously until we reached the present situation where it’s below the targets set by central banks.

In our case, we had double-digit inflation in the ’70s and rates of 5 to 7 per cent in the ’80s, then a long period within the target range until about six years ago. Since then it’s been below the target “despite the most expansionary monetary policy [the lowest interest rates] anyone can remember”.

So how is this experience of roughly 30 years of rising inflation, then 30 years of falling inflation explained? Macfarlane thinks there are about half a dozen reasons for the worsening of inflation in Australia.

For a start, the growth of production and employment during the 30-year post-war Golden Age was stronger than any period before or since. We had high levels of protection against imports, with little or no competition from developing countries.

We had a strong union movement, confident that in pushing for higher wages it wasn’t jeopardising workers’ job prospects. We had a centralised system for setting wages, with widespread indexation of wages to the consumer price index.

Our businesses took a “cost-plus” approach to their prices. If wages or the cost of imported components rose, this could be passed on to customers, confident your competitors would be doing the same. That is, firms had “pricing power”.

Finally, businesses’, unions’ and consumers’ expectations about how fast prices would rise in future were quite low at the start of the period, but they picked up and, by the end, had become entrenched at a high rate.

“This macro-economic environment was clearly conducive to rising inflation, and it took one policy error to push it over the limit,” Macfarlane says.

Under the McMahon government – predecessor of the Whitlam government – fiscal policy was made expansionary even though the inflation rate was already 7 per cent. Monetary policy was eased, with interest rates remaining below the inflation rate. And the centralised wage-fixing system awarded 6 or 9 per cent pay rises.

So, that’s how we acquired an inflation problem. What changed in the second 30-year period of declining inflation? Macfarlane thinks “the defining feature of the later period was that, in the long struggle between capital and labour, the interests of capital took precedence over those of labour”.

That is, the bargaining power of labour collapsed. In most countries the labour share of gross domestic product has declined, with the profits share increasing. Wage growth has been restrained, union membership has shrunk and the inequality of income and wealth has increased.

“These features have been most pronounced in the US, but many other countries, including Australia, have shown most of the same signs,” he says.

Two main developments account for this change. First, globalisation. The rapid growth of manufactured exports from China and the developing world pushed down consumer prices. More importantly, businesses and workers in the rich world realised that firms or whole industries could be shifted to countries where wages were lower.

Businesses had lost pricing power and sought to maintain profits by cutting costs and reducing staff levels. Union members became more concerned with saving their jobs than pushing for higher wages.

Second, labour-saving technological advance. In manufacturing, sophisticated machines started replacing workers. In the much bigger services sector, advances in information and communications meant that armies of state managers, regional managers and other middle management were no longer needed. Clerical processes were automated. Call centres were cheaper than a network of offices. Customers could buy on the internet, without the need for shop assistants.

As the period of high inflation passed into distant memory, Macfarlane says, inflationary expectations fell. Inflation expectations – whose importance comes because they tend to be self-fulfilling – change very slowly. It took decades for them to rise in the earlier period and, now, after nearly three decades of moderate and low inflation, it will take a long time before higher inflationary expectations are rekindled.

I see much truth in Macfarlane’s explanation. But it certainly means there’s been a “fundamental shift” in the factors bearing down on the economy – the implications of which we’re yet to fully realise, let alone fix.

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Weak inflation tells us: it's the demand side, stupid

Despite the remarkable 1.9 per cent fall in the consumer price index in the June quarter, we face no imminent threat of deflation. But it’s not as improbable a fate as it used to be.

Apart from in headlines, one negative quarter does not deflation make. Deflation occurs when price falls are modest, widespread and continuous, the product of chronically weak consumer demand. Businesses cut their prices as the only way to get people to buy what they’ve produced. Their goal is not to make a profit, but to reduce their losses.

Paradoxically, deflation – which was dogging Japan not so many years ago – is to be feared. Why buy now if prices are falling? Why not wait until they’re even lower? But the longer consumers wait, the more prices fall. And the faster they fall, the more businesses cut production and lay off workers. The economy implodes.

By contrast, our fall was produced by cuts in two key government-controlled prices – for childcare and pre-schools – plus petrol prices. We already know these falls will largely be reversed in the present quarter.

Even so, all the other prices in the CPI basket of goods and services rose during the quarter by just 0.1 per cent. People are reluctant to buy during recessions, so businesses don’t raise their prices for fear of selling even less. It’s a safe bet inflation will stay negligible for as long as the recession lasts and for as long as it takes the economy to recover.

Trouble is, we had unduly weak price growth long before the coronasession. Our rate of inflation’s been below the bottom of the 2 to 3 per cent target range for almost six years. The Reserve Bank has been struggling to get it up into the target, "Goldilocks" range without success.

Point is, when you have a problem with high inflation, you have a problem with the supply side of the economy. Supply isn’t keeping up with demand, so something needs to be done to get the economy’s production growing faster and more efficiently.

Conversely, when inflation isn’t a problem but high unemployment is, you have a problem with demand side of the economy. Consumers aren’t spending enough and businesses aren’t investing enough.

But too-low inflation isn’t the only indicator that demand and supply are out of whack. Another sign is record low interest rates. They’re low not just because inflation is so low, but also because “real” interest rates – the lenders’ above-inflation reward for letting other people use their money – have also fallen.

Why? It can only be because the amount of money savers have available to lend (the “supply of funds”) exceeds the amount home-buyers, businesses and governments want to borrow to cover their investment spending (the “demand for funds”). That real interest rates have been falling for years is another sign that our problem is chronic deficient demand, not inadequate supply.

One consequence of this is that the authorities’ ability to encourage borrowing and spending by cutting interest rates has been exhausted. So “monetary policy” has done its dash, leaving “fiscal policy” – the budget – as the only instrument left for the government to use to support the economy during the recession and then to stimulate growth.

If it wants more spending in the economy, the government must do it itself.

There’s just one difficulty. During the period in the 1970s and ‘80s when it was clear the developed economies had a major problem with inflation – meaning the supply side was chronically unable to keep up – the conventional wisdom emerged that the short-term management of the economy should be left to monetary policy, with fiscal policy reserved to help with other, medium-term issues.

This approach fitted neatly with the conservative side of politics’ preference for Smaller Government. Our Liberals have come to view macro-economic management in largely party-political terms: we use monetary policy; Labor uses fiscal policy. We follow neo-classical economics; Labor follows Keynesian economics. We cut government spending and taxation; Labor loves to spend and tax. We worry about deficient supply; Labor worries about deficient demand.

This political ideology approach to macro management can’t cope with the developed economies’ tendency to switch from long periods when supply and inflation are the big problem to long periods when demand and unemployment are the big problem.

You can see this in the Morrison government’s obvious reluctance to spend enough to limit the economy’s contraction to two successive quarters, despite our continuing struggle to contain the virus. You see it in Morrison’s desire to move on to “reforms” aimed at improving the supply side.

Both political sides see that wage growth is too weak at least partly because the productivity of labour is improving only slowly. But the Liberals’ ideological approach to macro tells them the answer to low productivity is more supply-side reform, whereas a pragmatic, more contemporary analysis says it seems obvious that if consumer demand is weak, business investment will be weak and if business investment in the latest technology is weak it’s no surprise that productivity improvement is slow. It’s the demand side, stupid.

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No progress on wages, but we’re getting a better handle on why

In days of yore, workers used to say: another day, another dollar. These days they’d be more inclined to say: another quarter, another sign that wages are stuck in the slow lane. But why is wage growth so weak? This week we got some clues from the Productivity Commission.

We also learnt from the Australian Bureau of Statistics that, as measured by the wage price index, wages rose by 0.5 per cent in the three months to the end of December, and by just 2.2 per cent over the year - pretty much the same rate as for the past two years.

It compares with the rise in consumer prices over the year of just 1.8 per cent. If prices aren’t rising by much, it’s hardly surprising that wages aren’t either. But we got used to wages growing by a percentage point or so per year faster than consumer prices and, as you see, last year they grew only 0.4 percentage points faster.

It’s this weak “real” wage growth that’s puzzling and worrying economists and p---ing off workers. Real wages have been weak for six or seven years.

So why has real wage growth been so much slower than we were used to until 2012-13? Various people, with various axes to grind, have offered rival explanations – none of which they’ve been able to prove.

One argument is that real wage growth is weak for the simple and obvious reason that the annual improvement in the productivity of labour (output of goods and services per hour worked) has also been weak.

It’s true that labour productivity has been improving at a much slower annual rate in recent years. It’s true, too, that there’s long been a strong medium-term correlation between the rate of real wage growth and the rate of labour productivity improvement.

When the two grow at pretty much the same rate, workers gain their share of the benefits from their greater productivity, and do so without causing higher inflation. But this hasn’t seemed adequate to fully explain the problem.

Another explanation the Reserve Bank has fallen back on as its forecasts of stronger wage growth have failed to come to pass is that there’s a lot of spare capacity in the labour market (high unemployment and underemployment) which has allowed employers to hire all the workers they’ve needed without having to bid up wages. Obviously true, but never been a problem at other times of less-than-full employment.

For their part, the unions are in no doubt why wage growth has been weak: the labour market "reforms" of the Howard government have weakened the workers’ ability to bargain for decent pay rises, including by reducing access to enterprise bargaining.

But this week the Productivity Commission included in its regular update on our productivity performance a purely numerical analysis of the reasons real wage growth has been weak since 2012-13. It compared the strong growth in real wages in the economy’s “market sector” (16 of the economy’s 19 industries, excluding public administration, education and training, and health care and social assistance) during the 18 years to 2012-13 with the weak growth over the following six years.

The study found that about half the slowdown in real wage growth could be explained by the slower rate of improvement in labour productivity. Turns out the weaker productivity performance was fully explained by just three industries: manufacturing (half), agriculture and utilities (about a quarter each).

A further quarter of the slowdown in real wage growth is explained by the effects and after-effects of the resources boom. Although the economists’ conventional wisdom says real wages should grow in line with the productivity of labour, this implicitly assumes the country’s “terms of trade” (the prices we get for our exports relative to the prices we pay for our imports) are unchanged.

But, being a major exporter of rural and mineral commodities, that assumption often doesn’t hold for Australia. The resources boom that ran for a decade from about 2003 saw a huge increase in the prices we got for our exports of coal and iron ore. This, in turn, pushed the value of our dollar up to a peak of about $US1.10, which made our imports of goods and services (including overseas holidays) much cheaper.

This, of course, was reflected in the consumer price index. When you use these “consumer prices” to measure the growth in workers’ real wages before 2012-13, you find they grew by a lot more than justified by the improvement in productivity.

In the period after 2012-13, however, export prices fell back a fair way and so did the dollar, making imported goods and services harder for consumers to afford. So there’s been a sort of correction in which real wages have grown by less than the improvement in labour productivity would have suggested they should. Some good news: this is a one-time correction that shouldn’t continue.

Finally, the study finds that a further fifth of the slowdown in real wage growth is explained by an increase in the profits share of national income and thus an equivalent decline in the wages share.

Almost three-quarters of the increase in the profits share is also explained by the resources boom. It involved a massive injection of financial capital (mainly by big foreign mining companies, such as BHP) to hugely increase the size of our mining industry – which, as the central Queenslanders lusting after Adani will one day find out, uses a lot of big machines and very few workers. Naturally, the suppliers of that capital expect a return on their investment.

But harder to explain and defend is the study’s finding that more than a quarter of the increase in the profits share is accounted for by the greater profitability of the finance and insurance sector. Think greedy bankers, but also the ever-growing pile of compulsory superannuation money and the anonymous army of financial-types who find ways to take an annual bite out of your savings.

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Living in the post-inflation era turns out to be no fun

It’s Christmas shopping time, when the bills mount up and your money never goes far enough. So how come people are saying the inflation rate should be higher? I thought inflation was meant to be a bad thing?

It’s a good question when one of those people is Reserve Bank governor Dr Philip Lowe. He keeps saying we need to get unemployment lower and inflation back up into the 2 to 3 per cent target range. (At last count the annual rate of increase in consumer prices was "only" 1.7 per cent. I can remember when, for a brief period in the 1970s, it was 17 per cent.)

The short answer is that Lowe doesn’t see higher prices as a good thing in themselves. Rather, he sees them as a means to an end. Or better, as a symptom or by-product of something that is a good thing.

Why do prices rise? Because the demand for goods and services – the desire to purchase them – is growing faster than the supply of them – our businesses’ ability to produce them. So the rate of price inflation is a symptom or sign of strong demand.

And strong demand for goods and services is a good thing because it means the economy is growing and so is employers’ need for workers to help produce more goods and services. Employment increases and unemployment falls.

So Lowe wants to see higher prices simply because they’re a means to the end of lower unemployment. What’s more, increased employer demand for labour relative to its supply makes labour – particularly skilled labour – scarcer and so puts upward pressure on its price, otherwise known as wages.

And, as he’s often said, Lowe would like to see employers paying higher wages than they are, because consumer spending – consumer demand – is so weak at present mainly because wages are hardly growing faster than consumer prices, and real wages are the main thing that drives consumer spending.

All that make sense? Good – because now I’ll give you the more complicated answer. Surely, although strong demand is good for the economy, it would be better if supply was just as strong, meaning we could have growth in jobs and living standards without any inflation?

That makes sense in principle, but not in practice. The managers of the macro economy believe we need some inflation, though not too much. For two reasons. First, though you’ll find this hard to credit, economists are sure our consumer price index (like other countries’ CPIs) overstates inflation.

That’s because the official statisticians are unable to pick up all the cases where prices rise not simply because the firm’s costs have risen, but because the quality of the product has been improved. If so, aiming for a measured inflation rate of zero would require you to crunch the economy hard enough to make actual inflation less than zero – that is, prices would be falling.

The second reason is that sometimes, when the economy is growing too strongly, wages rise too much, prompting firms to lay off workers. Trouble is, workers hate having their wages cut. But if you’ve got a bit of inflation in the system, you can cut wages in real terms simply by skipping an annual pay rise, which workers find less unpalatable.

When the Reserve Bank set its target for inflation in the early 1990s, it settled on 2 to 3 per cent a year ("on average over the medium term"). It thought such a range would overcome both problems and insisted such a target range constituted "practical price stability".

But things in our economy and all the advanced economies have changed a lot since the 1990s. Demand has been chronically weak relative to supply since the global financial crisis and, in consequence, inflation rates have been below-target everywhere.

Some people have suggested we move to a lower, more realistic target range, but Lowe has resisted, arguing that to do so would lower firms’ and workers’ expectations about inflation, making our weak-demand problem even worse. He may be right.

But now try this thought. Inflation is 1.7 per a year, while wages are growing by 2.2 per cent and workers aren’t at all happy. I’ve had several top economists agree with my contention that, if we could wave a magic wand and raise both inflation and wages by, say, 2 percentage points, so that wages were growing by 4.2 per cent, workers would be a lot less discontented.

Why? Because of a phenomenon that economists used to talk about a lot in in the 1960s, but rarely mention today, called "money illusion". People who aren’t economists keep forgetting to allow for inflation. If so, the era of very low inflation isn’t proving to be much fun.

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Why government-controlled prices are soaring

As if Scott Morrison didn’t have enough problems on his plate, we learnt last week that government-administered prices are rising much faster than prices charged by the private sector.

Last week my colleague Shane Wright dug out figures from the bowels of the consumer price index showing that, over the almost six years since the election of the Abbott government in September 2013, the prices of all the goods and services in the CPI basket have risen by just 10.4 per cent, whereas the government-administered prices in the basket rose by 26 per cent.

Some of those "administered" prices actually fell and others rose by less than prices overall. But let’s do what everyone does and focus on the really big increases.

Behavioural economics tell us that people’s perceptions of the cost of living are exaggerated by a ubiquitous mental shortcut psychologists call "salience". We tend to remember the things that leapt out at us at the time and forget all the things that didn’t.

So, for instance, we vividly remember the shock we got when we opened our electricity bill and saw how huge it was and how much it had increased.

In round figures, the cost of secondary education rose by 30 per cent over the period, childcare by 27 per cent, postal costs by 27 per cent, hospital and medical services by 36 per cent, council rates by 21 per cent, cigarettes by 109 per cent, gas prices by 16 per cent and electricity by 12 per cent (most of the bigger increase came during the term of the previous Labor government).

Not hard to see that the government has a huge salience problem. Plenty of scope there for the punters to convince themselves the cost of living is soaring.

But what should Morrison do? At a glance, the problem's obvious: government prices rising much faster than market prices say governments are hopelessly wasteful and inefficient. So expose the government to competition and the waste will be competed away, to the benefit of all.

Sorry, the true story’s much more complicated. Indeed, part of the problem is the backfiring of governments’ earlier attempts to make the provision of government services "contestable".

Let’s look deeper. For a start, some of the increase in administered "prices" is actually increases in taxation. The doubling in cigarette prices is the result of the phased massive increase in tobacco excise begun by Malcolm Turnbull.

Local council rates work by applying a certain rate of tax to the unimproved land value of properties. State governments usually cap the extent to which the tax rate can be increased, but the base to which it’s applied soars every time there’s a housing boom.

Postal costs rise because we want to continue being able to post letters to anywhere in Australia at a uniform price, even though we're actually doing it less and less, thus sending economies of scale into reverse. Australia Post would have been privatised long ago if any business thought it could make a profit from the business without scrapping the letter service.

The doubling in the retail prices of the now largely privatised (but still heavily regulated) electricity industry over the past decade is the classic demonstration that attempts to introduce competition to monopoly industries are no simple matter and can easily backfire.

The cost of childcare has been rising over the years because governments have been raising quality standards – staff-child ratios, better educated and paid workers. Is that bad? This formerly community-owned sector has long been open to competition from for-profit providers without this showing any sign of helping to limit price increases.

Even so, childcare is heavily subsidised by the federal government. This government’s more generous subsidy scheme caused the net out-of-pocket cost to parents (which is what the CPI measures) to fall a little last financial year.

The modest suggested fees in government schools wouldn't have risen much over the past six years. If private school fees have risen strongly despite the heavy taxpayer subsidies going to Catholic and independent schools, it’s because the number of parents willing to pay them shows little sign of diminishing. Hardly the government’s problem.

Detailed figures show that the out-of-pocket costs for pharmaceuticals rose by less than 6 per cent (thanks to reforms in the pharmaceutical benefits scheme) and for therapeutic goods fell a few per cent, while for dental services they kept pace with the overall CPI, leaving the out-of-pocket costs of hospital and medical services up by a cool 36 per cent.

That tells you private health insurance is falling apart. Add the continuing problems with needs-based funding of schools, and electricity and gas prices, and the scope for further efficiency improvements in healthcare, and you see the Morrison government has plenty to be going on with.

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Worried Lowe flouts convention to push for wage rises - now

The most important piece of local economic news this week was no news: the wage price index remained stuck at an annual growth rate of 2.3 per cent for yet another quarter. I’ve said it before but I’ll keep saying it until it’s sunk into the skull of every last politician: we won’t get back to healthy growth in the economy until we get back to healthy growth in wages.

That’s because economies are circular: all of us standing in a circle, buying and selling to everyone else. What’s the main thing people in the circle sell? Their labour. What do they do with the wages they earn? Buy stuff from the rest of the economy.

Business people (and Coalition politicians) are very conscience of the truth that wages are a cost to business. They’ve thus long had the attitude that wages should be kept as low as possible.

But equally, wages are income to wage-earners, and by far the biggest source of income for the nation’s nine million households. So the less wages grow, the less growth there is in the income households use to buy the goods and services produced by the nation’s businesses. Not good.

Get it? In the end, business has as much to lose from weak wage growth as workers do. This is the bit that many businesspeople and politicians don’t get. They’re so used to seeing the economy as my lot versus the other lot, they can’t see that, as the Salvos say, "we’re all in this together".

People – even the media – keep saying wages are flat. That’s not true. What’s true is that, according to the Australian Bureau of Statistics, the rate at which wages are rising has been flat, at 2.3 per cent a year, for the fourth quarter in a row.

In fact, wage growth has been surprisingly low since the end of 2013 – five and a half years ago.

Another point to be clear on is that it’s not low wage growth, as such, that’s the problem. If consumer prices weren’t growing, annual wage growth of 2.3 per cent wouldn’t be bad. It would be fantastic.

So it’s the rate at which wages are growing relative to the growth in consumer prices that matters. Real wages, in other words.

Standard economic theory says that, provided their real growth is no faster than the rate of improvement in the productivity of labour (that is, output per hour worked), wages can grow faster than prices without causing increased inflation.

What’s more, if wage-earners are to get their fair share of the benefit from improved productivity, real wages should be growing in line with the medium-term trend (average) rate of growth in labour productivity, which is about 1.1 per cent a year.

And because wages are the greatest single factor driving household income, household income is the greatest single factor driving consumer spending, and consumer spending accounts for about 60 per cent of gross domestic product, the economy won’t be back to a healthy rate of growth until real wages are back to growing pretty much in line with average productivity improvement.

Which, it turns out, is a bit of a worry. Why? Because it isn’t happening and doesn’t look like happening any time soon.

In the April budget, the government confidently predicted that wage growth would return to something approaching the old normal, accelerating to 2.5 per cent over the year to June this year, then 2.75 per cent by next June, and 3.25 per cent by June the year after.

We learnt this week that, as measured by the wage price index, wages fell short of the first hurdle, coming in at 2.3 per cent rather 2.5 per cent.

Worse, last week we learnt that even the Reserve Bank doesn’t share the government’s optimism.

The Reserve’s revised forecasts now see no advance on 2.3 per cent by June next year, and only the tiniest improvement to 2.4 per cent in two years’ time.

Admittedly, contrary to my contention that we won’t get to decent growth in the economy until we get decent growth in wages, the Reserve is predicting that real GDP will have strengthened to a healthy 2.7 per cent by June next year, and an even healthier 3 per cent by June 2021.

With wage growth forecast to continue weak, the Reserve is expected this improvement to happen with out much help from stronger consumer spending.

So how? Mainly through strong growth in business investment spending, exports and public sector spending on infrastructure.

Consumer spending would be helped a bit by the latest tax cuts and the cuts in interest rates. Other help would come from the falling dollar’s improvement to the price competitiveness of our export and import-competing industries, the brighter outlook for mining investment, and some stabilisation of the housing market.

Maybe. I remain sceptical. And if his behaviour last week is any guide, Reserve governor Dr Philip Lowe is pretty worried about the continuing weakness in wage growth.

It is simply not done for leading econocrats to tell employers they should be paying higher wages. But that’s just what Lowe did in his appearance before the House economics committee.

"At the aggregate [overall] level," he said, "my view is that a further pick-up in wages growth is both affordable and desirable."

Not after we’ve achieved greater productivity improvement, please note, but now. By how much does he think wages should be growing? By about 3 per cent a year, as he’s said on various occasions.

What’s more, federal and state governments – Labor as well as Coalition - should be setting the private sector a better example – or "norm" in Lowe's words – by raising the 2 to 2.5 per cent caps they’ve imposed on their own employees’ wage rises.

Thank goodness somebody’s minding the shop.

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Star pupil Philip Lowe gives tips on why inflation is so low

Reserve Bank governor Philip Lowe started his study of economics at high school in Wagga Wagga and finished it with a PhD from the Massachusetts Institute of Technology. Much thanks to his teacher, Mrs King, whose teaching style convinced him economics was interesting as well as important.

The great attraction of high school economics is its emphasis on linking theory to current events.

According to a speech he gave last week, when Lowe did the HSC in 1979, the standard exam question was: why does Australia have both high inflation and high unemployment ("stagflation") and what’s the government doing about it?

In those days there was much interest in the "misery index", which adds the inflation rate to the unemployment rate. We got to peaks well above 20 per cent. Today, however, it’s below 7 per cent.

As the Australian Bureau of Statistics advised this week, the consumer price index rose by just 1.6 per cent over the year to June. Which means it’s been below the Reserve’s inflation target of "between 2 and 3 per cent, on average, over the medium term" for almost five years.

So Lowe’s guess is that, these days, exam questions are likely to ask: why is inflation so low at the same time as unemployment is also low – and what’s the government doing about it?

Just to be of help, he told us how he’d answer the question – which is one of interest and importance to all of us, not just youngsters preparing for their finals.

He started by noting that very low inflation has become the norm in most economies. At present, three-quarters of advanced economies have an inflation rate below 2 per cent.

There’s no single answer, he says, but there are three factors that, together, help explain what’s happened.

First, the credibility of the monetary "frameworks" that central banks eventually adopted when, in the second half of the 1970s, they realised inflation was way too high and needed to be got under control.

It wasn’t until the early '90s that our Reserve Bank adopted its present target for inflation which, as Lowe says, helped cement low inflation “norms” in the economy. In econospeak, it provided an anchor for business and unions’ expectations about how much prices were likely to rise over the next year or two.

"Many people understand that if inflation were to pick up too much, the central bank would respond to make sure the pick-up was only temporary,” Lowe says.

It would do so by raising interest rates and so discouraging borrowing and spending, of course. Economists call this the "monetary policy reaction function".

(It’s one of the reasons for the old view among economists that attempts to use the budget to stimulate demand by cutting taxes or increasing government spending wouldn’t achieve much. The central bank, fearing the stimulus would push up inflation, would react by raising interest rates and so stymie it. In the new world of continuing weak demand and too-low inflation, however, central banks are most unlikely to react to budgetary stimulus in such a way, meaning the new view is that budgetary stimulus is very effective.)

Has inflation targeting worked? Well, annual inflation has averaged 2.4 per cent since the target was adopted, so it certainly seems to have.

The second part of Lowe’s explanation for very low inflation is that spare capacity to produce goods and services (including spare workers who are unemployed or under-employed) in many advanced economies means there’s little upward pressure on prices.

That certainly seems the case in Australia. Our unemployment rate could go a lot lower than its present 5.2 per cent without causing wages to take off – especially with our under-employment rate of 8.3 per cent.

Our labour market seems to be more flexible – and less inflation-prone - than it used to be.

The third part of his explanation is that changes in the structure of the economy caused by technology and globalisation seem to be keeping prices low.

For one thing, digitisation and globalisation seem to be lowering the cost of producing many goods. The entry of China and other emerging economies into the global trading system has added hundreds of millions of factory workers to the global market.

The prices of manufactured goods in the advanced economies have barely increased over the past couple of decades.

For another thing, globalisation and advances in technology are making markets more contestable and increasing competition. This is extending beyond manufacturing to almost every corner of the economy, including the services sector.

Historically, most services couldn’t be traded across national borders. But globalisation – driven mainly by advances in information and communication technology – means many services can now be delivered by somebody in another country.

Examples include preparation of architectural drawings, document design and publishing, and customer service roles (a nice name for call centres). As well, many tasks such as accounting and payroll have been automated.

The internet and its digital “platforms” have revolutionised services such as retail, media and entertainment, and transformed how we communicate, and search for information and compare prices.

"These changes are having a material effect on pricing, with services price inflation lower than it once was. Many firms know that if they don’t keep their prices down, another firm somewhere in the world might undercut them," Lowe says.

"And many workers are concerned that if the cost of employing them is too high, relative to their productivity [an important qualification], their employer might look overseas or consider automation."

More broadly, using the internet for better “price discovery” keeps the competitive pressure on firms.

The end result is a pervasive feeling of more competition. And more competition normally means lower prices.

What’s the government doing about low inflation and the deficient demand that is part of its cause?

Well, if you mean the elected government, the short answer is: not nearly enough. Especially when you remember how little scope the Reserve Bank has left to cut interest rates.

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News from the shopping trolley: retailers are doing it tough

If I told you that a big reason we're feeling such cost-of-living pressure is the increasing profits of the big supermarket chains, department stores, discount stores and other retailers, would you believe me? A lot of people would.

But that would just show how little we understand of the strange things happening in the economy in recent years. The economy in which we live and work keeps changing and getting more complicated, the digital revolution is disrupting industry after industry, but we have far too little time to check out what's happening – especially behind the scenes – so we rely on the casual impressions we gain along the way and on our long-held views about who's ripping it off and who's getting screwed.

Which are often off-beam. Perhaps because in many respects it's a good news story, few people realise the way digital disruption is putting retailing - a pretty big part of the economy, and a big part of household budgets - through the wringer.

If this meant retail staff were being laid off in their thousands we'd have heard about it. If it meant big retail chains were jacking up their prices, we'd have been told.

Instead, increased competition between retailers is making it much harder than usual for them to put up their prices, and causing some prices to fall.

It's all explained by Matthew Carter in an article in last week's Reserve Bank Bulletin, using data from the Australian Bureau of Statistics and the Reserve's regular contact with many medium and large retailers.

The article covers about a third of the "basket" of goods and services bought by Australian households, the changing prices of which are measured by the consumer price index. That is, not just food and other things you buy in supermarkets, but clothing and footwear, furniture, household items and much else, though not motor vehicles and fuel. Nor other classes of consumer spending not done through retailers, such as the costs of housing, healthcare and education.

Since the early 2000s, the increased competition in retailing has come first from online shopping – competition not just between local and overseas retailers, but between those local retailers who use the internet and those who don't, as well as between those who do.

The other main source of increased competition in retailing is the arrival of big new international companies, such as Aldi, Costco and, of course, Amazon, which is both online and a big new arrival from overseas. (The article doesn't mention two other disruptive developments: the advent of "category killers" such as Officeworks and Bunnings, and the decline of the department store.)

The basic model of markets used by economists assumes that businesses compete with each other mainly on price. In real-world Australia, however, the two, three or at most four big companies that dominate most markets much prefer to compete via product differentiation, marketing and advertising, and avoid price competition.

That's what online shopping has changed. And it's not just that the internet has made it infinitely easier for shoppers to compare prices. It's also that, on the net, it's much easier to compare prices than to compare colours or quality.

And when a big foreign player decides to try to break into an established market, price competition is the main way it tries to gain market share.

The result is that retailing has become more price conscious. And retailers are telling the Reserve Bank that their customers have become more price sensitive – which isn't surprising considering how slowly their wages are growing.

Nor does it matter much that, so far, not many people do their grocery shopping online, or that Aldi is still much smaller than Woolies or Coles. The others have protected themselves from losing market share by matching their rivals' lower prices.

Another effect of digitisation is to make it a lot easier for retailers to change their prices (as well as to find out what their rivals are charging). And the greater price consciousness of their customers means that 60 per cent of retailers now review their prices weekly or even daily.

This means many retailers more frequently discount their prices - put them "on special" - and make the discounts deeper.

The Reserve Bank's survey of retailers shows the main reasons they lower prices is because their competitors have cut their prices or because demand has weakened.

Carter has analysed the Bureau of Statistics' industry statistics and found that the net profit margins of both food and non-food retailers had fallen by about 1.75 percentage points (that's 1.75¢ in every dollar of sales) since 2011-12.

It may not sound much, but it is – especially in supermarkets, which are low-margin, high turnover businesses. Further analysis confirms that this decline comes from reduced ability to mark-up wholesale prices, rather than higher operating costs.

However, retailers are fighting back, trying to improve their mark-ups by offering more own-brand products (cuts out the wholesaler) and more premium brands (higher mark-up), while some non-food retailers are joining the supermarkets in moving from the traditional "high-low" pricing strategy ("specials" and frequent "sales") to an "everyday low price" strategy. By selling more, they gain more power to bargain with wholesalers.

Of all the things that are making our lives tough, higher retail prices ain't one of them.

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Interest rate cuts are coming, which isn't good news

The Reserve Bank may have decided not to cut interest rates right now, but it’s likely to be only a few months before it does start cutting, and it’s unlikely to stop at one. So, is it just waiting until after the election? I doubt that’s the reason.

The Reserve has moved interest rates twice during election campaigns – raising them in 2007 (much to the surprise of Peter Costello, whose mind was on politics at the time) and cutting them in 2013 – so, had Reserve governor Dr Philip Lowe considered an immediate cut was needed, I doubt he would have hesitated to make it.

The Reserve acts independently of the elected government, so it is – and must be seen to be - apolitical. Lowe’s predecessor, Glenn Stevens – who instigated both those previous moves – decided that the only way to be genuinely apolitical was for him to act as soon as he believed the best interests of the economy required him to, regardless of what the politicians were up to at the time.

I doubt his former deputy and understudy, Lowe, would see it any differently.

So, is Lowe’s judgement that a rate cut isn’t needed urgently bad news or good for Scott Morrison – or, conversely, for Bill Shorten?

First point: stupid question. What matters most is whether it’s good or bad news for you and me, and the economy we live in, not the fortunes of the people we hire to run the country for us. The rest is mere political speculation.

The media invariably judge a fall in interest rates to be good news and a rise bad news. But this is far too narrow a perspective. For a start, it assumes all their customers have mortgages and none are saving for a home deposit or for retirement. The retired are absolutely hating the present protracted period of record low interest rates.

For another thing, it assumes that our loans or our deposits are the only things that matter to our economic wellbeing. That the central bank’s movement of interest rates has no implications for, say, our prospects of getting a decent pay rise, or of hanging onto our job.

The fact is that central banks use the manipulation of interest rates to influence the rate at which the economy’s growing. They raise rates when everything’s going swimmingly and, in fact, needs slowing down a bit to keep inflation in check.

They cut interest rates when things aren’t going all that well – when, for instance, low wage increases are causing anaemic growth in consumer spending and this is giving businesses little incentive to expand their operations, or when a rise in unemployment is threatening.

Penny dropped? A cut in interest rates is a portent of tougher times ahead, whereas a rise in rates says the good times are rolling and will keep doing so for a while yet.

So it’s not at all clear that, had he cut rates, Lowe would have been doing Morrison a favour politically and doing Shorten a disservice.

In Treasurer Josh Frydenberg’s budget speech a month ago – it seems an eternity – he used the phrase “strong growth” 14 times. Turned out Morrison was basing his case for re-election on the claim that the Coalition had returned the economy to strong growth – after the mess those terrible unwashed union people had made, as they always do.

That claim is now not looking so believable. It was in trouble even before the budget, when we learnt in March that the economy had suffered a second successive quarter of weak growth, slashing the rise in real gross domestic product during 2018 to just 2.3 per cent – rather than the 3 per cent the Reserve had been talking about.

This was the first sign that, having left its official interest rate steady at 1.5 per cent for more than two and a half years, the Reserve needed to think about using a cut in rates to help push the economy along.

The next sign came just a fortnight ago, when the release of the consumer price index showed that, while some prices fell and others rose during the March quarter, on balance there was no change in the cost of the typical basket of goods and services bought by households.

This caused the annual rate of price increase to fall from 1.8 per cent to 1.3 per cent – at a time when the Reserve had gone for more than three years assuring us it would soon be back in the Reserve’s target range of between 2 and 3 per cent.

So, quite a blow to the Reserve’s assurances that the economy was getting stronger, and a sign it should be thinking seriously about cutting rates to kick things along. (Prices tend to rise faster the faster the economy is growing so, paradoxically, very low inflation is a worrying sign.)

In which case, why has Lowe hesitated? Because, I suspect, he’s waiting for the third shoe to fall. Employment has been growing faster than you’d expect in a weak economy, so he may be waiting for signs it’s slowing, too.

And he’d want to be confident a cut in interest rates didn’t restart the housing boom in Sydney and Melbourne, which has left too many people with far too much debt.

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Economy’s health requires reform of earlier wage reforms

Can you believe that many economists were disappointed by this week’s news from the Australian Bureau of Statistics that consumer prices rose by only 2.1 per cent over the year to June?

Why would anyone wish inflation was higher than it is? Well, not because there’s anything intrinsically terrific about fast-rising prices, but because of what a slow rate of increase tells us about the state of the economy.

It’s usually a symptom of weak growth in economic activity and, in particular, of weak growth in wages. Prices and wages have a chicken-and-egg relationship. By far the most important factor that pushes up prices is rising wages.

But, as measured by the bureau’s wage price index, wages rose by just 2.1 per cent over the year to March, roughly keeping up with prices, but not getting ahead of them.

We’re used to wages growing each year by 1 per cent-plus faster than prices, but such “real” growth hasn’t happened for the past four years or so (which probably explains why so many people are complaining about the high “cost of living” even when price rises are so small).

It’s important to understand that wages can grow faster than prices without that causing higher inflation, provided there is sufficient improvement in workers’ productivity – output per hour worked – to cover the real increase.

Of late we’ve had that productivity improvement, but all the benefit of it has stayed with business profits, rather than being shared between capital and labour by means of increases in real wages.

I’ve said it before and I’ll keep saying it until it’s no longer relevant: the economy won’t be back to healthy growth until we’re back to healthy growth in real wages. That’s for two reasons.

First, in a capitalist economy like ours, the “social contract” between the capitalists and the rest of us says that the people without much capital get their reward mainly via higher real wages leading to higher living standards.

Second, consumer spending accounts for more than half the demand for goods and services in the economy; consumer spending is done from households’ income, and by far the greatest source of household income is wages.

So, as a general proposition, if wages aren’t growing in real terms, there won’t be much real growth in household income and, in that case, there won’t be much real growth in consumer spending. And the less enthusiastic we are about buying their stuff, the less keen businesses will be to invest in expansion.

Get it? Of all the drivers of economic growth, by far the most important is real wage growth. If your economy’s real wage growth’s on the blink, you’ve got a problem. You won’t get far.

Economists used to believe that real wage growth in line with trend improvement in the productivity of labour was built into the equilibrating mechanism of a capitalist economy. A chap called Alfred Marshall first came up with that idea.

But with each further quarter of weak price and wage increase it’s becoming clearer it was a product of industrial relations laws that boosted workers’ economic power by helping them form unions and bargain collectively with employers.

As has happened in most rich countries, our governments, Labor and Coalition, have been “reforming” our wage-fixing process since the early 1990s by reducing union rights and encouraging workers to bargain as individuals rather than groups.

Trouble is, governments have been weakening legislative support for workers and their unions at just the time that powerful natural economic forces – globalisation and greater trade between rich and poor countries, “skill-biased” technological change, the shift from manufacturing to services – have been weakening the bargaining power of labour.

Whoops. In hindsight, maybe not such a smart “reform”. My guess is it won’t be long before governments decide they need to promote real wage growth by restoring legislative support for unions and collective bargaining.

But how could they go about this? Well, Joe Isaac, a distinguished professor of labour economics at Monash and Melbourne universities and a former deputy president of the Industrial Relations Commission, outlines a plan in the latest issue of the Australian Economic Review.

Isaac proposes four main reforms of the reforms. First, the Fair Work Act should be less prescriptive, giving the Fair Work Commission greater discretion to intervene in industrial disputes, to conciliate and, if necessary, impose an arbitrated resolution on both sides.

Second, the present restrictions on unions’ right to enter workplaces should be eased to allow them to check the payments made to union and non-union employees, as well as to recruit members.

The widespread allegations of illegal underpayment of wages suggest “a serious lack of inspection of pay records” – formerly a task in which unions had a major role. “These breaches in award conditions cannot be discounted as a factor in the slow wages growth,” Isaac says.

Third, legislation against “sham contracting” – employers reducing their workers’ entitlements by pretending those employees are independent contractors – should be tightened.

Fourth, the present procedures and delays before workers are allowed to strike while negotiating new wage agreements should be reduced.

As well, bargaining and striking over multiple-employer or industry-wide agreements should be permitted. As economists long ago established, real wage rises should reflect the economy-wide rate of productivity improvement, not the experience of particular firms.

Industry-wide and multiple-employer agreements allow unions to support people working in small and medium businesses, not just those in big businesses and government departments.

Such bargains are known as “pattern bargaining” and are illegal at present. It’s true that pattern bargaining was pressed and extended to other industries unjustifiably in years past, but the commission should have the power to prevent pattern bargaining where it’s not justified.

Now, many employers may view Isaac’s proposed “reregulation” of wage fixing with alarm. What’s to stop the return of unreasonable union behaviour and excessive wage rises?

Ah, that’s just the point. What will prevent it is all those other developments that have weakened workers’ bargaining power.

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Retailers affecting the economy in ways we don’t see

As uncomprehending punters complain of the soaring cost of living, and the better-versed ponder the puzzle of exceptionally weak increases in prices and wages, don't forget to allow for the strange things happening in retailing.

It's a point the Reserve Bank's been making for months without it entering our collective consciousness the way it should have.

The debate over the cause of weak price and wage growth has been characterised as a choice between a "cyclical" (temporary) problem as we recover only slowly from the resources boom, and a "structural" (long-lasting) problem caused by the effects of globalisation and industrial relations "reform" that's robbed employees of their power to bargain collectively.

To the annoyance of protagonists on both sides, I've taken a bit-of-both position. But the Reserve has raised a different structural contributor to the problem: the consequences of greatly increased competition in a hugely significant sector of the economy, retailing.

The media have focused on the digital disruption aspect, with the arrival in Oz of the ultimate category killer, Amazon Marketplace.

But that happened only late last year and, although retailers may already have been tightening up on wage increases and other costs in anticipation of greater threat from online competitors, much of those consequences are yet to be felt.

Of greater significance to date is the arrival of new foreign bricks-and-mortar competitors such as Aldi and Costco.

As Dr Luci Ellis, an assistant governor of the Reserve, said last month, "Australia has seen a marked increase in the number of major retail players. Foreign retailers have entered the local market in recent years and continue to do so.

"This has also induced the existing players to reduce their costs to stay competitive, for example by improving inventory management. This has probably been a bit easier for larger or less-diversified retailers than for smaller firms.

"Whether through lower costs, narrower margins or a combination of both, this competitive dynamic has weighed on prices for consumer durables.

"And for staples such as food, competition and related changes in pricing strategies (such as 'everyday low price' strategies) have contributed" to keeping prices low.

If you doubt that adds up to much, try this. According to the consumer price index, prices of food and non-alcoholic beverages (including restaurant and take-away meals) were almost unchanged over 15 months to December, and rose only 3.6 per cent over the previous six and a half years.

Prices of clothing and footwear fell by 3.5 per cent over the 15 months to December, and fell by 4.6 per cent over the previous six and a half years.

Prices of furniture and household equipment fell by 1.5 per cent over the 15 months to December, and rose by just 4.5 per cent over the previous six and a half years.

As Reserve Bank governor Dr Philip Lowe has remarked, this is good news for consumers, although not for some retailers – nor their employees, for that matter.

Sometimes I think everyone would be a lot happier if prices and wages were growing by 4 per cent a year rather than 2 per cent. This would be a delusion, of course, but the beginning of behavioural economic wisdom is to realise that illusions abound in the economy.

Low inflation is not a bad thing to the extent that it's caused by increased competition forcing down businesses' profit margins – and goodness knows the two big supermarket chains have plenty of profitability to cut into.

Indeed, the benefit to consumers – who, remember, include all employees – makes competition-caused low inflation a good thing. (What's not a good thing is low inflation caused by weak demand.)

And particularly where increased competition involves innovation and digital disruption, it usually brings consumers greater choice and convenience, not just lower prices.

The downside of increased competition and digital disruption, however, is the adverse consequences for employees. Some may lose their jobs; many may find pay rises a lot harder to extract from bosses worried about whether their business has a viable future.

Retailing is our second biggest employer, with about 1.2 million full-time and part-time workers. And whereas the overall wage price index rose by 2.1 per cent over the year to December, in retailing it rose by only 1.6 per cent. This was lower than all other industries bar mining, on 1.4 per cent.

It's likely to be some years yet before the disruption of retailing has run its course, and this may mean structural change in the sector acts as a continuing drag on wage growth overall.

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CPI a more accurate measure of living costs than we imagine

Ask any pollie, pollster or punter in the pub and they'll all tell you there are no political issues hotter than the soaring cost of living. But this week the Australian Bureau of Statistics issued its consumer price index for the December quarter.

Oh no. It showed prices rising by 0.6 per cent in the quarter and a mere 1.9 per cent over the year to December.

That's a soaring cost of living? What are these guys smoking? Has the government got to the statisticians? Or do the bureaucrats sit in some office in Canberra making up the numbers?

None of the above. In truth, the bureau puts an enormous amount of expertise, care and effort into making the CPI as accurate as possible. Which is not to say the indicator is without its limitations – nothing in the real world is.

The care is shown in an explanatory paper the bureau issued this week to accompany its latest six-yearly updating of the index.

The CPI is purpose-built to measure changes in the price of a fixed quantity of goods and services bought by people living in metropolitan households.

"Metropolitan" means the eight capital cities, and the households include wage-earners, the self-employed, self-funded retirees, age pensioners and social welfare beneficiaries. That covers almost two-thirds of all Australian households, leaving out only those in regional areas.

The index measures the change in the price of a metaphorical basket containing fixed quantities of goods and services bought in each of the capital cities. It looks at thousands of prices of individual items, divided into 87 expenditure classes, 33 sub-groups and 11 major groups.

These are: food and beverages (accounting for 16 per cent of the total basket), alcohol and tobacco (7 per cent), clothing and footwear (4 per cent), housing (23 per cent), furnishings, household equipment and services (9 per cent), health (5 per cent), transport (10 per cent), communication (3 per cent), recreation and culture (13 per cent), education (4 per cent), and insurance and financial services (6 per cent).

How does the bureau know which particular goods and services to include in the basket and, more especially, what "weight" (relative importance) to give each class of expenditure?

Every six years it conducts a survey of more than 10,000 households, asking them to keep diaries of the spending they do. As spending patterns change over time, it updates the contents and the weights given to the items in the basket.

This week it applied new weights derived from the household expenditure survey it conducted in 2015-16.  From now on, however, the weights will be updated yearly.

The bureau checks the prices consumers are being charged by regularly visiting shops and offices, by phoning businesses, and, increasingly, by checking online supermarket sites and records of scanner transactions in stores.

It checks the prices of items at least once a quarter, but more frequently if prices – petrol, for example – keep changing. It aims to show the average price charged during the quarter.

It measures the retail prices we actually pay, so prices include the goods and services tax, and excise taxes, embedded in them, but also any government price subsidies for items such as private health insurance or childcare.

It takes account of widespread "specials", provided the items are of normal quality. It seeks to measure "pure" price changes, meaning it tries to exclude price changes attributable to a change in the quality or quantity of the latest version.

If some producer tries to disguise a price increase by leaving the price of a can of baked beans unchanged, but reducing the amount of beans, the bureau uses the actual price increase per gram.

When the latest laptop or mobile phone is more powerful than the previous model, or does more tricks, the bureau tries to take account of this quality improvement by calculating the underlying or "pure" price change – often a price fall.

But if the bureau takes so much care to measure price changes accurately, why do its figures invariably seem much lower than our impression of the price rises we've experienced?

Short answer: because we don't take nearly as much care as it does. We don't keep meticulous records, but form impressions. And, as behavioural economists tell us, our memories of prices changes are subject to predictable biases.

Price changes we don't like stick in our minds, while those we don't mind are soon forgotten. We remember clearly a few big price increases – the shock we got when we saw our quarterly electricity bill – but don't remember price falls (of which there are far more in these days of digital disruption). And it never occurs to us to take account of all the many items whose prices hardly change.

As a statistician would say, we don't attach the right weights to the price changes (including zero changes) that come our way.

So, for instance, we carry on (justifiably) about ever-rising power prices, but forget that electricity accounts for just 2.2 per cent of the average household's total consumer spending.

Of course, no particular household's experience is likely to be perfectly represented by such a broad average. The index lumps together people in different cities, smokers and non-smokers, drinkers and non-drinkers, renters, mortgagees and outright home owners.

The bureau tries to reduce this problem by also publishing special living cost indexes for certain types of households. Over the year to September, in which the CPI rose by 1.8 per cent, living costs rose by 1.5 per cent for employee households, 1.6 per cent for self-funded retirees, 1.7 per cent for age pensioners, and by 2.1 per cent for unemployed households.

Sorry, but the notion that the prices I pay rose way more than other people's did is just another of our happy self-delusions.

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The real reason you're feeling the pinch

Maybe it's just me, but these days the more politics I hear on TV or radio, the less time it takes for my blood to boil. Just ask my gym buddies. "No point shouting at the radio, Ross, they can't hear you."

Last week, for instance, I heard the erstwhile Queensland leader of One Nation carrying on about what a big election issue the rising cost of living was. There was the cost of electricity ... but he ran out of examples.

High on my list of things I hate about modern pollies is the way they tell us what they think we want to hear, not what we need to know. Then they wonder why voters think they're phoneys.

As someone who's spent his career trying to help people understand what's going on in the economy, it's galling to hear politicians reinforcing the public's most uncomprehending perceptions.

The crazy thing is, the widespread view that our big problem is the rapidly rising cost of living is roughly the opposite of the truth.

It's true the price of electricity has been rising rapidly, lately and for many years, for reasons of political failure. But electricity accounts for just a few per cent of the total cost of the many goods and services we buy.

And the prices of those other things have been rising surprising slowly, with many prices actually falling. You hadn't noticed? Goes to show how wonky your economic antennae have become.

Annual increases in consumer prices have been so low for the past three years that the governor of the Reserve Bank, Dr Philip Lowe, is worried about how he can get inflation up into his target zone of 2 to 3 per cent.

Why would anyone worry that the cost of living isn't rising fast enough? Because, though it's hardly a problem in itself, it's a symptom of a problem buried deeper.

Which is? Weak growth in wages over the past four years. Rising wages are the main cause of rising prices. Price rises have been small because wage rises have been small.

It's the weak growth in wages that's giving people trouble balancing their household budgets – a problem they mistakenly attribute to a fast-rising cost of living.

What they've grown used to over many years is wages rising by a per cent or so each year faster than prices, and they've unconsciously built that expectation into their spending habits. When it doesn't happen, they feel the pinch.

For the past four years, wages have barely kept pace with the weak – about 2 per cent a year – rise in consumer prices.

This absence of "real" wage growth is a problem for age pensioners as well as workers because pensions are indexed to average weekly earnings – meaning they too usually rise each year by a per cent or so faster than prices.

Why would any economist worry that wages weren't growing fast enough? Because, as well as being a cost to business, wages are the greatest source of income for Australia's 9.2 million households.

And when the growth in household income is weak, so is the growth in the greatest contributor to the economy's overall growth: consumer spending.

It might seem good for business profits in the short-term, but weak wage growth eventually is a recipe for weak consumption and weak growth in employment. What sounded like a great idea at first, ends up biting business in the bum.

Weak wage and price growth is a problem in most rich countries at present, meaning it's probably explained by worldwide factors such as globalisation and technological change.

In a speech last week, Lowe opined that a big part of the problem was "perceptions of increased competition" by both workers and businesses.

"Many workers feel there is more competition out there, sometimes from workers and sometimes because of advances in technology" and this, together with changes in the nature of work and bargaining arrangements, "mean that many workers feel like they have less bargaining power than they once did".

"It is likely that there is also something happening on the firms' side as well . . . Businesses are not bidding up wages in the way they might once have. This is partly because business, too, feels the pressure of increased competition."

Lowe says a good example of this process is increased competition in retailing, where competition from new entrants (Aldi, for instance) is putting pressure on margins and forcing existing retailers to find ways to lower their cost structures.

Technology is helping them do this, including by automating processes and streamlining logistics (transport costs). The result is lower prices.

"For some years now, the rate of increase in food prices has been unusually low. A large part of the story here is increased competition. The same story is playing out in other parts of retailing. Over recent times, the prices of many consumer goods – including clothing, furniture and household appliances – have been falling," Lowe says.

"Increased competition and changes in technology are driving down the prices of many of the things we buy. This is making for a tough environment for many in the retail industry, but for consumers, lower prices are good news."

True. Which is why I find it so frustrating when idiot politicians keep telling people the cost of living is soaring.

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How we delude ourselves about the cost of living

Let me tell you a home truth no politician would dare to: We don't have a problem with the cost of living. In fact, consumer prices rose at the unusually slow pace of just 1.9 per cent over the year to June.

I don't expect that telling you you're kidding yourself will make me popular – which, of course, is why the pollies aren't game to tell you, even though they know it's true.

But how on earth can I claim there's no problem with the cost of living when, in this column only last week, I wrote that the retail cost of electricity had more than doubled over the past decade, and was now rising by a further 15 or 20 per cent?

Because electricity bills do not the cost of living make.

Households have to buy a hundred other things apart from power, and it's changes in the combined cost of all those things that determine what's happening to the cost of living.

Trouble is, humans are not good at keeping track of what's happening to all the prices of the 101 things we buy.

We tend to focus hard on some price changes, while ignoring loads of others. Which ones do we focus on? The ones that are rising rapidly, of course.

Which ones do we ignore? The ones that don't change much. We even fail to notice or remember for long the prices that are falling.

Nothing's better suited to misleading us than bills for water, gas or electricity. They tend to come only once a quarter, which makes them a large dollar figure.

When they're a lot higher this quarter than they were last – and when we struggle to find the money to pay them – we're left convinced the cost of living is out of control.

Actually, it says we could be better at budgeting – could hold more spare cash aside for unexpected bills. But it's easier for us to shift the blame to someone else – the gov'ment, for instance.

All this subjectivity is why we get a reasonably realistic picture of changes in the cost of living only by accepting what we're told by the people whose job it is to keep a careful record of price changes, the Australian Bureau Statistics, with its consumer price index.

The index measures changes in the prices of a fixed basket of goods and services bought by households in the eight capital cities. The bureau conducts a detailed survey every six years to ensure the items in the basket reflect changes in our purchasing habits.

The basket includes 87 different classes of expenditure, covering – as we'll see – far more than just the things we buy in supermarkets. The bureau checks about 100,000 individual prices every quarter, across the eight capitals, mainly by having its workers go into shops to see for themselves, or by contacting service providers.

It tries to get the actual prices people are paying, and to adjust for changes in quality and quantity (such as when a producer reduces the size of a tin or package without reducing the price commensurately).

The index confirms that, over the decade to June, the price of electricity rose by 116 per cent, while the combined price of all the goods and services in the basket rose by just 26 per cent.

How is that possible? Because most prices rose by far less than electricity did, some prices actually fell, and – get this – electricity accounts for less than 2 per cent of the cost of all the many things we buy. (For age pensioners, it's 3.4 per cent.)

Let's look closely at that 1.9 per cent rise in consumer prices over the year to June. It includes a 7.8 per cent rise in electricity prices.

But food prices (accounting for 17 per cent of the total cost of the basket) rose 1.9 per cent, alcohol and tobacco prices by 5.9 per cent, clothing and footwear prices fell by 1.9 per cent, housing costs rose 2.4 per cent, while prices for furnishings and household equipment and services were unchanged.

Out-of-pocket health costs rose 3.8 per cent, transport costs rose 2.1 per cent, communication costs (mainly phones) fell 3.8 per cent, recreation costs (mainly audio, visual and computer costs) fell 0.1 per cent, education costs (mainly private school and uni fees) rose 3.3 per cent, and the cost of insurance and financial services rose 2.1 per cent.

This means prices fell for categories worth 17 per cent of the total cost of the basket and were unchanged for a category worth 9 per cent of the basket.

The truth so many people can't see is not that the cost of living – consumer prices – has been rising rapidly, but that wages are only just keeping up with prices.

Over the four years to March, consumer prices rose by 8.3 per cent, whereas the index for wage rates rose by an unusually weak 9.2 per cent.

What's really making us dissatisfied is not that the cost of living is rising rapidly, but that our wages haven't been rising by the 1 per cent or so per year faster than prices that we're used to, thus preventing us from increasing our standard of living.

That is, our ability to buy a bit more stuff than we bought last year.

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