Australia has a problem or two

Working-age population growth is running at about 1.7% a year, while potential output growth is only around 2%, largely because productivity growth is close to zero.

Thirty years of Australian monetary policy in six charts

The Reserve Bank of Australia (RBA, the Bank) has had an inflation target roughly since 1993. Thirty years is long enough to judge it. This post does that with six charts, five of them built from my own models, and it reaches a verdict that is kinder to the bank before the GFC than after it. The bank has had two failures since then. They were different in kind, and only one of them was a choice.

The Australian Economy Right Now

Four numbers rarely line up the way they have this year. Growth sits above potential. Unemployment sits below the non-accelerating inflation rate of unemployment (NAIRU). Inflation sits above the target band. And the cash rate sits above the neutral rate, r*, but still short of what a standard Taylor rule would prescribe. Put together, these estimates describe an economy running hot while policy leans against it, but not hard enough.

Growth Has Overtaken Potential

Headline GDP growth through the year is running at 2.14%, although most of that growth happened in the tail end of 2025. Growth in the first half of 2026 was much more modest.

Who Fights Inflation

Australian inflation took off in 1973 and did not get back below five per cent, and stay there, until 1991. Eighteen years. Germany peaked at 7.9 per cent and was under 5 within three. The United States peaked at 14.8 and took nine. We peaked at 17.5, and the Reserve Bank's own 1992 conference on disinflation ranked Australia poorly on the unemployment cost of getting there, putting it down to high real rigidities.

Australia has an inflation problem

 Underlying inflation is running at 4.9% annualised and climbing.

QE and the Estimated Neutral Rate

TL;DR

Money for long-term borrowing moves freely across borders, so liquidity is a global phenomenon. QE bought bonds from asset holders and paid in cash. With this cash they bought other assets, everywhere and in every class. Asset prices rose worldwide, including in countries that never ran a QE programme of their own.

That was inflation, in a market the consumer price index does not cover. And bidding an asset's price up is bidding its yield down, so the same event was a global fall in borrowing costs.

None of this began in 2009. Bernanke saw low rates in 2005 and diagnosed a global savings glut as the cause, favouring a structural explanation over a liquidity one.

Most econometric models that estimate the neutral rate are fitted to consumer prices, output and interest rates. Asset prices are not among the inputs. So the figure they report is the rate that is neutral for groceries, and it has nothing to say about whether borrowing was running ahead of the capacity to service it.

There is a second problem underneath. The models infer the rate from two relationships that a decade of successful stabilisation had flattened, leaving the history of the policy rate itself as the main thing to lean on. Policy rules then took that estimate as an input, and naturally recommended something close to the policy already in place.

Estimation needs variation, and stabilisation exists to remove variation. A central bank that succeeds gradually erases the evidence it needs to keep doing its job.

The liquidity story does the work of several. It explains why asset prices boomed where no programme ran, why consumer prices stayed quiet and then surged in 2021 when the same mechanics reached households instead, and why every country's estimate fell together despite different demographics, deficits and growth.

For a decade, the rate that would have kept borrowing serviceable sat far above the one the models report. That is not a measurement problem. It is a specification problem, and a specification problem returns a confident number to the wrong question.

Inflation Targeting vs nGDP Targeting

What Are We Talking About

Today's blog post is very technical. We are talking about which variable should be the focus of a central bank when it sets interest rate policy. Most of the world's central banks use an inflation target, typically around 2 per cent, although Australia has a 2 to 3 per cent target band and within that it targets the 2.5 per cent mid point. An alternative which is often promoted is nominal gross domestic product (nGDP) targeting, where the bank aims to maintain a steady growth rate or path for nGDP.

Why is the Aussie dollar so strong?

Australian productivity has gone backwards since 2019. Unit labour costs are running ten points above the United States from a common base. The goods trade balance in trend-terms has fallen from above 13 billion dollars a month at the 2022 peak to barely 3 billion, with the latest print briefly negative. Inflation has reaccelerated above the target band on every measure. By any fundamental read, the Australian dollar should be weakening. It isn't. It has rallied from briefly below 0.60 last year to above 0.72 now and the trend is looking up.

The answer is the interest-rate differential. Everything else is detail.

Central Bank Purposefulness, Take Two

I wrote about central bank purposefulness a couple of months ago, and on reflection I was not happy with what I had written. The argument was buried under too much scaffolding. This is a second attempt, stripped back to what I actually wanted to say. The core argument is that a central bank should follow three principles:

• Don't be a cowboy;
• No surprises; and
• Stay in your lane.

The first is about how the Bank moves, the second about how it communicates, and the third about what it comments on. Each is a piece of the same underlying point. The Bank's credibility is the asset that makes its instrument work, and credibility is built and lost through the ordinary discipline of how the institution carries itself. Cowboy rate setting depletes it. Surprises deplete it. Editorialising on matters outside the mandate depletes it. Everything else in the post is consequences of those three.

Should the RBA Raise Rates in May 2026

The Monetary Policy Board meets on 4 to 5 May. The cash rate sits at 4.10 per cent after two consecutive 25 basis point hikes in February and March, the first reversals of the easing cycle that ran through 2025. Markets are pricing roughly a 60 per cent chance of a third hike. The case for or against another move depends on what the data say about the underlying inflation problem, not on what borrowers would prefer to hear.

The framework set out in Inflation: Causes, Diagnosis and Cures is a useful discipline here. Diagnose first. Decide second. Skipping the diagnostic step is how public commentary about monetary policy generates more heat than light. So let me work through the diagnosis using the five drivers the framework identifies, then turn to the policy question.

Inflation: Causes, Diagnosis and Cures

The Bloomberg Commodity Index, a broad-based benchmark covering energy, metals, and agricultural commodities, is up at the moment. In the past this index has been correlated with periods of higher inflation.

CPI Reform Won't Fix Housing

Introduction

There is a growing chorus of voices arguing that Australia's Consumer Price Index is broken. The CPI, they say, fails to capture the real cost of living because it excludes house prices – the single largest purchase most Australians will ever make. The frustration is genuine. The lived experience of millions of Australians – particularly younger ones, renters, and aspiring first home buyers – diverges sharply from what the headline inflation number suggests. When the Treasurer announces that inflation is under control and real wages are growing, people who cannot afford to buy a home, or who are watching mortgage repayments consume an ever-larger share of their income, are understandably sceptical.

But the argument that the CPI should be reformed to include house prices, land costs, or mortgage repayments rests on a fundamental confusion about what housing affordability actually is. Housing is not one problem. It is three distinct problems, each driven by different forces, each requiring different policy responses, and each moving in different directions in response to the same policy lever. No single price index can combine all three in a way that remains conceptually coherent, policy-usable, and suitable as a monetary target – and trying to force them into one would produce a measure that misleads more than it illuminates, while damaging one of the most important instruments in Australia's macroeconomic framework.

Underlying the whole debate is a confusion between two things that are not the same: a headline indicator of lived economic pressure, and a target variable for monetary policy. The public wants the first. The Reserve Bank needs the second. Forcing a single number to do both jobs is the source of most of the confusion – and it cannot be resolved by reforming the CPI, because the two purposes are structurally in tension.

Let's start with the three housing affordabilities.

Q4 2025 National Accounts Update

An update to my December 2025 Economic Outlook

Introduction

Every national accounts release contains both good and bad news, and Q4 2025 is no exception.

GDP per capita is improving. Labour productivity is moving in the right direction. Real wages have reached a new high. These are genuine improvements, not statistical noise, and they deserve acknowledgement.

But the balance of this release tilts toward concern rather than celebration. Domestic inflation remains stubbornly above target. Unit labour costs are still too high. Government spending continues to crowd out private activity. And the RBA is now reversing rate cuts it should not have made.

This is not a crisis. It is not the end of the world. But the list of issues requiring attention is longer than the list of developments deserving applause.

The Headline: GDP Growing above Inflationary Speed Limit

GDP growth has lifted from the anaemic sub-1.5% rates seen through much of 2024. But 2.56% annual growth is not a recovery – it is the economy running above its compressed speed limit of roughly 2%. Australia’s potential has fallen over the past decade as productivity stagnation has lowered the economy’s supply capacity.

The December outlook argued that near-2% growth reflects supply constraints rather than demand deficiency. The Q4 data confirms this: growth has accelerated and domestic inflation remains elevated. That combination only occurs when an economy is at/above capacity. There is no spare room here.

Monetary Policy: Asymmetries, Lags, and the Case for Purposefulness

Introduction

The textbook story of monetary policy is deceptively simple: raise rates to cool inflation, cut rates to stimulate demand. In practice, the transmission mechanism is neither symmetric nor uniform. Different channels operate at different speeds, rate hikes bite harder and faster than rate cuts heal, and the labour market – the variable central bankers care most about – is the slowest to respond. Understanding this structure explains both why central banks should be deliberate in their actions, and why a rapidly falling unemployment rate during above-band inflation is one of the most worrying signals in macroeconomics.

Multi-factor Productivity (MFP): The Solow Residual

The Puzzle

In the late 1990s, something remarkable was happening to Australian productivity. Multi-factor productivity growth – the portion of economic growth not explained by adding more capital or labour – was running at over 2% per year. A decade later, it had collapsed to near zero, and by some measures had turned negative. What happened?

This question matters enormously for policy. Productivity growth is, in Paul Krugman's memorable phrase, "not everything, but in the long run it's almost everything." It determines living standards, fiscal sustainability, and the scope for wage growth without inflation. Yet when we try to measure it, we encounter a fundamental problem: productivity isn't directly observable. We can only infer it as a residual – the growth left over after accounting for measurable inputs.

This residual approach, pioneered by Robert Solow in 1957, has become the workhorse of productivity measurement. It has also been called "the measure of our ignorance." Understanding both its power and its limitations is essential for anyone working with macroeconomic data.

November Jobs: Market Caution May Be Misplaced

Markets moved quickly to reprice RBA rate expectations after today's November labour force release. But in their rush to declare the economy sicker than we thought, they may be overlooking the bigger picture.

The labour market is cooling, but not enough to ease inflation pressure. In fact, once you adjust for participation and NAIRU dynamics, the labour market remains tighter than it appears - and inflation is re-broadening. Markets may be reacting to the wrong signal.

The Neutral Rate Debate: What Comes After 15 Years of Emergency?

Introduction

Before 2008, nobody argued about the neutral interest rate. It was textbook macroeconomics: the neutral real rate (r) roughly equals trend real economic growth (g). For Australia, that meant r around 3-4%. Add the inflation target of 2.5%, and you get a nominal neutral rate of 5.5-6.5%.

The RBA cash rate averaged about 5.5% from 1993 to 2007, bouncing around neutral as the economy cycled through expansions and contractions. Rates went up when inflation threatened, down when growth weakened, but always gravitating back to that 5-6% centre of gravity.

This wasn't controversial. It was Econ 101.

Then Lehman Brothers collapsed, and everything we thought we knew about interest rates went out the window.

Building a Toy Macro Model for Australia

Bayesian approach to estimating NAIRU, potential output, and the output gap

Australia's first truly domestic inflation cycle in decades

Australia may be facing its first truly domestic inflation cycle in decades. Productivity stagnation, rising labour costs and entrenched services inflation have boxed the RBA into a narrow corridor. Inflation will ease only when structural constraints - not just interest rates - are addressed.

The Q3 inflation surprise

The Q3 2025 inflation print surprised on the upside, with annual headline inflation once again exceeding the Government’s 2–3 per cent target band. The Government has downplayed the result as statistical noise, arguing that inflation remains on a trajectory towards the centre of the band. That may prove correct - very occasionally rogue prints happen - but the data are not yet conclusive. For now, the result makes it increasingly unlikely that the RBA will cut rates at its November 2025 meeting.