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.

Seeing Australian r-star through different windows

How do you estimate something you cannot observe?

That is the basic problem with r-star, the neutral real interest rate. In the standard monetary-policy framework, it is the real interest rate consistent with the economy operating at potential and inflation stable. Put the real policy rate below r-star and monetary policy should stimulate demand. Put it above r-star and policy should restrain it.

But r-star is not a market price we can look up. It has to be inferred from other things we can observe, using some model of how those things relate to it.

I started trying to estimate an Australian r-star using the standard Holston-Laubach-Williams (HLW) model. That attempt failed. The Australian data did not contain enough information for the model to identify the relationship it needed to recover r-star.

That failure led to a different question. If I cannot see Australian r-star through the HLW model, can I see it through other windows?

I have now tried three. One looks at international and Australian bond markets. One looks at the RBA's own interest-rate decisions. The third imposes the IS relationship that HLW failed to estimate and works backwards to the r-star required to make it hold.

These are not minor variations on the same model. They obtain their information about r-star from quite different places. All three estimate cleanly. More importantly, all three recover a recognisably similar low-frequency history: Australian r-star was much higher, fell substantially over the decades before COVID, and has risen again since the pandemic.

But they disagree materially about exactly where r-star sits.

That combination is the interesting result. I have a much better window on the direction of Australian r-star than I do on its level.

R-star as an international price

I have written about r-star twice this year. The first post tried to pin down Australia's natural rate the standard way, a Holston-Laubach-Williams state-space model, trend growth and the IS curve doing the identifying work. It couldn't be done. The IS curve coefficient on the real rate gap came out at around minus 0.05, against quarter-to-quarter noise of about 0.7. A signal one-fourteenth the size of the noise floor cannot identify anything. Every variant I tried failed the same way, the latent r-star collapsing onto whichever prior I fed it.

The second post started with the premise that liquidity is global, and in every country investment seeks out the best returns in the world. The standard approach to r-star instead asks Australian output and inflation to reveal the real interest rate that balances desired saving and investment, as though that equilibrium were fundamentally domestic. But saving and investment now meet in a global capital market. A single global market still leaves room for a country-specific wedge, the way a single global oil market leaves room for regional basis differentials between Brent, WTI and everything else. The wedge is the local story. The level it sits on top of is not.

This post takes that global understanding and uses it to model Australia's neutral real rate of interest, r-star. World r-star plus the Australian wedge gives Australian r-star, rather than Australian output, inflation and trend growth being asked to produce one on their own. Australia's own market tells you the wedge on top, not the underlying price.

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.

The New Keynesian Synthesis, Explained

When a central bank moves the cash rate, it’s acting on a specific model of how the economy works. That model is the New Keynesian synthesis, and it’s the closest thing modern economics has to an operating manual for monetary policy. Every inflation target, every rate decision, every line in a central bank statement about “returning inflation to target” comes out of this framework. Understanding it is the difference between watching the news cycle of rate rises and cuts and actually seeing the logic behind it.

This isn’t a history of how these ideas came together, nor an account of what exactly got synthesised between classical and Keynesian economics. It’s a walk through the intuition: how the pieces of the model fit together, and where they hold up worse than the theory suggests.

Output and Output Gaps

Every economy has a speed limit. Economists call it potential output, or Y*. It represents how much an economy can produce when its workers, factories, and capital are all fully but sustainably employed. Actual output (also known as GDP or Y) moves around this limit. The difference between the two, Y minus Y*, is called the output gap. Sometimes it’s negative and Y sits below Y*, and resources go idle. Sometimes it’s positive and Y pushes above Y*, and something has to give.

Potential: the speed limit for the economy

Every few weeks someone describes potential growth as the economy’s speed limit. The metaphor is useful, but it is attached to the wrong thing. The real speed limit is potential output, the level: the amount the economy can produce sustainably with inflation at target. Potential growth is only the rate at which that limit itself moves. The two answer different questions, and mixing them up produces bad readings of the cycle.

This post uses a small model of Australian potential output to make one point. Conventionally, the output gap is the difference between actual and potential output, a difference between two levels. This model goes one step further and splits that observed difference into an inflation-related component and a residual. Potential growth tells you how fast the potential level is moving. It does not tell you the sign of the gap, and neither potential growth nor observed GDP growth on its own tells you where inflationary pressure sits.

Two levels and the distance between them

MMT in Three Layers

I often find myself in conversation with supporters of Modern Monetary Theory, and for a long time I was mystified by what they are saying. This is the MMT I meet in argument and online, not the academic literature, which is more careful and more divided than any single account allows.

Over time I have come to think of MMT as three layers: a small set of accounting identities, a set of mechanisms, and a set of normative principles. Some are uncontroversial. Others are either inconsistent with the rest of MMT or simply impractical. What is most evident is that the identities do not establish the mechanisms, and the mechanisms do not establish the principles. If anything the arrow runs the other way: the mechanisms flow from the principles, and the identities are recruited afterward to make the whole look derived.

Three of the identities are mainstream economics; nothing new there. MMT adds a fourth claim and presents it as though it too were an identity, but it is not. It is the first of the mechanisms, an institutional design proposal wearing accounting's clothes. Of the six mechanisms, four rest on a technically true core the mainstream accepts but add reasoning or consequences it does not accept; the other two are institutional proposals the mainstream rejects outright. None of the principles are mainstream at all.

MMT did get one thing right: a government that issues its own free-floating currency cannot be forced into nominal default on its own-currency debt, and even mainstream central banks now accept as much. The disagreement is about everything the theory builds on top of that one sound insight. I will take the layers in the order MMT usually presents them, from the arithmetic up to the politics, because that is the order you meet them in argument.

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.

Finding r-star after the Great Divergence

TL;DR: r-star, the real neutral rate of interest, is one of the unobservable star variables in mainstream macroeconomics. It is notoriously hard to estimate. The Australian IS curve coefficient on the real-rate gap is small relative to macro noise, so the model cannot choose between a growth anchor, a bond-yield anchor, or a blend of the two. Those three approaches, drawing on Wicksell, imply a real r-star between roughly 1.5 and 2.6 per cent, and a nominal neutral cash rate between about 4.0 and 5.1 per cent. With the RBA policy cash rate at 4.35 per cent, policy is not extreme. The data alone does not say whether it is mildly restrictive or mildly accommodative. The post-GFC track record and Governor Bullock’s recent language both lean toward the yield-anchored interpretation, on which 4.35 per cent is mildly restrictive.

Finding r-star after the Great Divergence

After doing additional analytical work that further shaped my views, I have withdrawn my original post. 

Please see the replacement post here.

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.

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.

Stagflation: the Lead in Australia's Saddle

Previously I argued that the Reserve Bank's credibility is a critical defence against a repeat of the 1970s stagflation experience. That is true, but it is only half the story. The other half is the architecture around the central bank, which determines whether that credibility can do its work. 

This post is about the broader architecture necessary to manage inflation, told through the question that the set of charts below forced me to confront: Why did Australia take so much longer than everyone else to get inflation back under control after the 1973 oil shock? The UK, Japan and Italy all had an inflation peak higher than Australia's in the wake of the oil shock. All were broadly back towards pre-shock inflation levels in three to eight years. Australia took 15+ years. 

Stagflation

I grew up with stagflation. In the 70s and 80s it was the word everyone reached for, here and abroad. Inflation and unemployment were both pushing towards double digits at times. The misery index piling up month after month. And it stuck around. The United States got out because Paul Volcker (Chairman of the Federal Reserve 1979-1987) broke the back of US inflation at the cost of a brutal global recession in the early 1980s. Australia took longer to reset, and only fully closed the chapter with the recession we had to have in the early 1990s.

Australia's savings problem and the current account deficit

Introduction

Take a look at the chart above. At first glance it’s just two wiggly lines. But those two lines tell a story about the Australian economy that stretches back more than half a century – and it’s a story that affects everything from your mortgage rate to your superannuation.

The Australian Economy: Q4 2025

Introduction

I run several Bayesian macroeconomic models of the Australian economy. They fit the data to the model structure and estimate how much each variable is contributing to the key unobservables – the natural rate of unemployment and the potential growth rate. What follows is what those models are currently telling me.

But first, let's quickly recap on the RBA's policy rate, the current state of Australian inflation, and the current unemployment rate.

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.

How Interest Rate Targeting Works

The Main Channels

The RBA identifies four main transmission channels in its April 2025 Bulletin article on monetary policy transmission through the lens of its MARTIN and DINGO models (Mulqueeney, Ballantyne and Hambur 2025). Christopher Kent, as Assistant Governor (Financial Markets), added a fifth – the credit channel – in his October 2023 address to Bloomberg. These aren't exhaustive, but they're ones the RBA can quantify in its models. I'll come back to some others later.

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.