The 6-4-2 solution
Wages should be growing at 6 per cent a year, prices at 4 per cent, cash rate 2 per cent
A 5 per cent annual rate of inflation is not, in itself, a major problem. It has become evident that very low rates of inflation can be just as damaging as high inflation, by not allowing the Reserve Bank room to cut interest rates far enough when the economy is depressed. The 2-3 per cent target adopted in the 1990s made sense as a way to break the inflationary expectations built up over previous decades, but is now clearly too low. If inflation targeting is to be retained as a policy, the target should be raised to 4 per cent.
What is really needed though is a target rate of growth for wages, which have been stagnant for years and have lagged far behind prices in the recent upsurge. Wages should be increasing by 6 per cent a year, at least for the next couple of years. Achieving this will require not only caution in raising interest rates but the repeal of decades of industrial relations legislation explicitly designed to hold wage growth down.
If wages rose at 6 per cent a year, and workers shared fairly in productivity gains, inflation would be around 4 per cent. Assuming a neutral real interest rate of -2 per cent, that would be consistent with a 2 per cent target cash rate. Hence, the 6-4-2 solution