One of the biggest traps in Australian economics over the past decade has been worrying about non-tradable inflation. I fell into this trap myself prior to the May 2013 RBA meeting — for reasons which I hope will be apparent in a few minutes.
First of all, a re-cap of the facts. Prices pretty much always go up — except for over the last few years where traded goods prices have gone sideways.
We only have tradable and non-tradable CPI indices back to 1998, but over the early part of this period, non-tradable prices rose a little more quickly, but both tended to accelerate and slow according to some common cycle (the global business cycle).
So why should we not worry about non-tradable inflation? After all, it’s tradable inflation that’s holding down CPI, due to FX appreciation and that cannot go on forever?
Well, that’s because a rise in non-tradable prices relative to tradable prices is exactly what the textbook suggests.
RBA Gov Kent has a nice schema of the text-book dynamics in a speech he gave last year. He shocks mineral prices, and shows the consequences. I have re-produced the chart above.
Taking the ratio of the two lower panels in Gov Kent’s chart, you can see that the ratio of non-tradable prices to tradable prices ought to rise. That’s exactly what we’ve seen since the terms of trade started to rise: non-traded inflation has been higher than traded inflation.
Why does this occur? Because the higher terms of trade means that the prices of tradable goods are lower, and as a result we have more income to purchase non-traded goods and services. More demand means higher prices … just like micro 101.
So how does the theory work? Pretty well so far. When we look at the ratio of non-traded to traded prices against the terms of trade, you can see that the increase in the two match closely — up until the last few years.
If the textbook holds on the way down, what we should expect to see is a decline in the exchange rate and a rise in the relative price of tradable goods. This will probably play out as a rise in the real price of traded goods, which lowers real incomes, and therefore lowers demand for non-traded goods.
So why worry now, given that the terms of trade are falling?
Because the price ratio has just snapped in the ‘wrong’ direction, relative to the terms of trade. This is what a competitiveness problem looks like.
If non-traded prices are sticky, we may have trouble keeping a lid on inflation if the exchange rate falls quickly. If this were to occur, the transmission back to balance would be via a long period of higher unemployment (with larger deficits etc).