More economics 101 - capacity utilisation and inflation in Australia

Yesterday (19 November 2008) Malcolm Edey, Assistant Governor (Economic) at Australia's Reserve Bank, delivered a short speech to the Australia & Japan Economic Outlook Conference 2008 entitled The Economy in Late 2008: Conditions and Prospects. You can find the full speech here.

There were a couple of interesting graphs in the speech that I thought worthy of a comment because of the light they throw on existing economic problems.

The first graph shows capacity utilisation as measured by the NAB series.

You can see the current downturn clearly. Of more interest, you can see the scale of the crash into recession in 1990.

While I have no desire to see a repeat of 1990, it was quite dreadful from a business viewpoint, it does put the current talk of depression in context. I am sure that capacity utilisation will fall further, perhaps to 1990 levels, but this is not depression.

The second graph shows Australian inflation over the period since the start of 1996. You can see why the RBA was worried during the most recent past when Australian inflation suddenly spiked at the fag end of the boom.

Now there is something very important to note about this graph. Australia's peak inflation is much lower than it was during the stagflation of the 1970s or the end of the 1980s boom. I make this point because it changes the policy equation facing policy makers. We have much more scope to use fiscal policy than before without creating another inflationary round.

The next graph I found especially interesting. It shows the relative shift in prices for non-tradable goods and services as compared to tradables.

When you look at the graph you can see the way the rise in the price of non-tradables, essentially those parts of the economy not exposed to international price pressures, drove inflation. You can also see how the decline in the price of tradable goods - in part a reflection of China's growing role - initially cushioned price rises on the non-tradable side.

The non-tradable side may not be affected by international competition, but it is affected by the current downturn. We can expect price pressures to drop here.

The position on the tradable side is more complicated. I think that the China effect, the way in which growth of Chinese exports pushed prices down, has come to an end. On the other hand, all internationally traded goods will be under price pressure because of the global downturn. So price pressures should ease, offset to some degree in the Australian case by our currently depreciated exchange rate.

Again, the net effect is to give policy makers greater freedom for expansionary measures.