The Price of Stability

Australia risks settling into a low-productivity, high-population-growth equilibrium: stable yet stagnant. Ageing, cheap credit, and migration mask weak dynamism, keeping the natural rate of interest pinned low. Escaping the trap demands productivity, not inflation.

At Equilibrium

Imagine the Australian economy in perfect balance. Inflation sits neatly at 2½ per cent, the midpoint of the Reserve Bank’s target band. Unemployment hovers, say, somewhere between 4 and 4½ per cent – close to the NAIRU, the level that keeps wages and prices rising steadily but not dangerously. Growth is steady, output close to potential, and expectations anchored. There are no booms to restrain, no busts to repair.

If the Reserve Bank wanted to hold that equilibrium indefinitely, what cash rate would it choose? Adjusted for inflation, that’s the natural rate of interest – $r^*$ or r-star – the real rate that keeps the economy growing at its sustainable pace without pushing prices up or down. When the actual cash rate equals r-star, monetary policy is neutral. Below it, policy is accommodative and stimulates demand; above it, it restrains.

Economists estimate r-star using models that relate output, inflation, and employment to interest-rate settings. None is precise, but for Australia most results cluster around a real neutral rate of roughly ½ to 1 per cent. Add the midpoint of the inflation target and the nominal neutral cash rate sits near 3 to 3½ per cent. That’s the level consistent with stable prices and full employment – the centre of gravity around which the economy oscillates.

Why the Natural Rate Has Drifted Lower

Three decades ago, r-star was much higher. In the 1990s the real neutral rate probably sat around 2 per cent. Since then it has trended down, pulled by slow-moving structural forces that have reshaped saving, investment, and risk appetite.

Ageing and the savings surplus. A more mature demographic structure – with a larger share of late-career, high-saving cohorts and fewer young borrowers – raises aggregate saving relative to investment, pushing down the natural real rate. Superannuation inflows, rising wealth inequality, and cautious households have lifted national saving even as investment appetite weakened. Excess saving relative to investment pushes equilibrium real yields lower.

Slower productivity growth. When productivity rises briskly, firms compete for capital and rates rise to clear the market. When productivity stalls, investment demand fades and r-star falls. Australia’s labour-productivity growth has averaged barely 1 per cent a year since 2012 – half the pace of the reform era – and the neutral rate has sagged in tandem.

Global capital flows. Australia doesn’t set its equilibrium rate in isolation. Global investors arbitrage returns, and the worldwide “savings glut” that followed the global financial crisis dragged down yields everywhere. With global real rates near zero through the 2010s, Australia could not sustain higher ones without a damaging currency surge.

Policy credibility. Inflation targeting itself has reduced volatility. Once the public believed the RBA would hold inflation near 2–3 per cent, lenders stopped demanding large inflation premia. That credibility has been a public good – but it also lowered nominal and real interest rates across the curve.

Population and the Natural Rate

Australia’s strong migration program complicates this picture. Ageing drags r-star down, but high immigration pushes in the opposite direction. Each new cohort of migrants needs housing, infrastructure, and services before they have built savings. In the short run that raises investment demand relative to the domestic saving pool, nudging the equilibrium real rate higher.

Over time the effect moderates as migrants join the workforce and accumulate wealth, yet sustained population growth keeps Australia’s potential output expanding faster than that of most advanced economies. Migration, in other words, lifts the floor under r-star even as other forces press it down. It doesn’t transform the landscape, but it prevents a deeper slide.

The Productivity Drought and the Dollar

A prolonged drought in productivity growth – now stretching more than a decade – suppresses the natural rate and weakens the exchange rate. With fewer high-return investment opportunities, the marginal product of capital falls. Even at low interest rates, firms hesitate to expand because expected returns are poor.

A lower r-star means lower real yields; capital drifts abroad seeking better returns. The currency does the adjusting: the Australian dollar softens to offset the decline in real competitiveness. The floating exchange rate has been a silent shock absorber, disguising the underlying stagnation. But it also allows the low-productivity equilibrium to persist without visible pain, dulling the incentive for reform.

The Price of Stability

Modern Australia has become extraordinarily good at smoothing the business cycle. Automatic stabilisers, responsive fiscal policy, and a credible central bank prevent deep recessions. That resilience is a national asset – but it comes with a paradox. The better we get at suppressing volatility, the lower the natural rate of interest becomes.

When households and firms trust that governments will cushion every downturn, they demand less reward for risk. The economy becomes safer, but money becomes cheaper. Low rates encourage leverage and lift asset prices, which in turn make stability even more politically valuable. The system reinforces itself: macroeconomic calm produces financial inflation.

This is the quiet cost of stability. The instruments that protect households from shocks – fiscal insurance, forward guidance, liquidity support – also suppress the real return on capital. The economy trades dynamism for durability.

The Low-Productivity, High-Population-Growth Trap

Combine these forces and Australia risks drifting into a new equilibrium: a low-productivity, high-population-growth economy that feels stable yet slowly erodes its own dynamism. Migration sustains demand and headline GDP growth, while weak productivity and high saving keep r-star pinned low. Fiscal policy relies on population-driven expansion to balance the books; monetary policy relies on cheap credit to fund it.

Migration itself is not the cause of low productivity, but it enables the complacency that sustains it. Strong inflows keep GDP and tax receipts rising even when output per worker stalls. Policymakers can point to growth and jobs while ignoring stagnating efficiency. In that sense, migration masks the problem more than it creates it.

The loop is self-reinforcing: low productivity depresses r-star; low rates inflate assets; asset gains placate voters and blunt reform pressure; migration keeps GDP expanding; and the cycle repeats. Each turn of the loop trades dynamism for comfort.

The Asset-Price Channel

A persistently low r-star reshapes wealth and risk. When the cost of capital stays below the economy’s long-term growth rate, the value of land, equities, and infrastructure assets balloons. The distributional consequences are profound: owners of appreciating assets grow richer while wage growth flatlines.

This feedback loop reinforces the political popularity of stability. Voters dislike recessions but tolerate inequality that feels paper-based. As long as asset prices rise and unemployment remains low, the system appears healthy – yet its resilience rests on ever-lower real rates and ever-higher leverage. The more we succeed in taming volatility, the more fragile the structure becomes.

The False Cure: Inflation or Productivity?

A low natural rate leaves policymakers facing an uncomfortable choice: tolerate higher inflation or lift productivity. The arithmetic seems tempting. If the real neutral rate is only ½ per cent and inflation 2½ per cent, the nominal neutral rate is 3 per cent – leaving little room to cut before hitting the lower bound. Raise the target to (say) 3 or 4 per cent and the neutral nominal rate becomes 4½ per cent. Policy space restored, at least on paper.

Some economists – notably Olivier Blanchard – argue that modestly higher inflation targets (say, 3 rather than 2 per cent) would buy more room for conventional rate cuts with limited costs. Perhaps the arithmetic is right. But it remains a nominal answer to a real problem: it buys room to manoeuvre without rebuilding the economy’s capacity to produce (and Australia’s inflation target is already roughly half a point higher than the 2 per cent used by most Western peers).

Higher inflation raises the numbers on the dial without raising output per worker. It would erode purchasing power, punish savers, and, if done deliberately, risk unmooring inflation expectations. Once credibility weakens, risk premia rise, long-term yields jump, and real borrowing costs may increase rather than fall. For an open economy like Australia’s, whose exchange rate and bond yields are tied to global markets, a higher inflation regime would also invite a weaker currency and imported price volatility.

The durable alternative is to fix productivity. If productivity growth lifts, the marginal return on capital rises, investment demand strengthens, and r-star increases for the right reasons. A one-percentage-point rise in trend productivity growth could lift r-star by roughly the same margin, giving the RBA more room to manoeuvre and boosting real incomes without sacrificing credibility.

A credible productivity agenda would target three choke-points. First, competition: concentrated sectors–supermarkets, energy retailing, banking–need regulatory teeth that reopen space for entrants. Second, planning and housing: approval times that stretch years turn migration into land scarcity; a national fast-track regime could unlock supply. Third, skills: tilt migration and education funding toward engineering, energy, and digital capability rather than generalist degrees. These are not glamorous reforms, but they raise returns on capital and push r-star up for real reasons.

The Moving Anchor

The natural rate of interest is not fixed, nor entirely knowable. It shifts with demography, technology, and psychology – with how a society saves, invests, and manages risk. Australia’s r-star today is low because the country has become safer, older, and more risk-averse. Fiscal stabilisers and a credible central bank have tamed volatility, but they have also tamed returns.

The temptation will always be to lean on inflation or migration to keep growth alive. But neither substitutes for productivity. The only honest way to lift the natural rate is to raise the nation’s capacity to produce more from the resources it already has.

Complacent prosperity is comfortable, but it cannot last. The price of macro-stability has been a lower r-star. The next phase of prosperity will depend on whether Australia chooses to earn a higher one – not through inflation, but through ambition.