My main consideration, which I don’t think has received enough attention in debates about monetary policy (although Harry has certainly raised it), is that we have to get used to more expensive energy in the medium term. Real wages and/or profit expectations have to adjust downward (relative to trend). And if this means a contraction of labour supply and a lower full-employment level of activity, it needs to be recognised in targets for growth while that adjustment is underway. (On the other hand, if we’re on the backward-bending section of the aggregate labour supply curve, it’s a different story.)

Against that is my doubt that we can easily identify any equilibrium real wage level (or path), given the decline (relative to productivity) of the last decade. So the bottom line is that I really don’t know what to think.

Finaly, if JQ is right, and he usually is, the world economy will give us the slowdown we had to have anyway.

My short term concerns were based on two propositions. First, that the acceleration in domestic inflation is much more a product of overseas cost-push than domestic demand pull relative to productive capacity, being triggered mainly by a combination of (a) rising oil, energy and food prices (b) the indirect effects of these external cost-push forces and (c) a structural mismatch between demand and supply. In such circumstances, any attempt to curb aggregate domestic demand through higher interest rates will do little for inflation and only push up unemployment.

The second premise underlying my short term concerns was that the RBA may have under-estimated the strength of the cumulative deflationary forces already in the pipeline (the slow down in world economic growth, the high $A, potential wealth effects, the increased risk aversion in debt markets, the loss of trust, the lagged impact of past increases in borrowing rates etc.). These forces, I thought, would slowly but surely curb both domestic demand and some of the inflationary pressures. TWe did not require more interest rate rises which of course we got.

James, I think you query my first proposition on the ground that whether it is cost-push or demand pull, there is a need to curb inflationary expectations and preempt changes in wage demands and price settings. This is a fair point. But if my second proposition is correct, underlying inflation will ease off anyway (even without central bank action) – not so much in the Mrch quarter but the June and September quarters. This will deflate infaltionary expectations. It is indeed what Bernake has been repeatedly saying.

Still, the RBA has been fine tuning the economy brilliantly since the mid 1990s so it may well prove right on this occasion too. There is a case (which I do not accept but it is legitmate) that, although world and market events are uncertain, it is better to act firmly now and then cut interest rates later if necessary.

By the way, on the risk of a new wage-price cycle and worsening inflationary expectations, I really doubt that either Harper or the Unions can do much damage in the present decentralized labour market. And ACTU secretary Jeff Lawrence is right to remind us that higher managerial salaries have been growing by double digit figures and are now up to 50 to 100 times median earnings. It is ludicrous to argue that CEO remuneration is market determined when anyone who has served on a Board knows the CEO and related market is set by insiders for insiders. Nor are there effective shareholder disciplines in place. At a time when shareholders are taking a beating in part because of managerial greed and incompetence and at a time when the Rudd Government has taken the lead by freezing parliamentary remuneration, it is surely about time for some of our CEOs to show moral leadership and promise to keep their firms managerial pay unchanged for at least twelve months and subsequently link their remuneration more effectively to their companys performance relative to its peers. If some our leaders take the lead, others will follow.

The forward curve for some of the commodities isn’t showing any appreciable slowdown for 09. Coal is a good example. Although coal prices have been hit with bad weather causing shortages to develop and prices to spike…. some of the stuff went from $40 a ton to $130 on the spot market, the forward curve is showing only a about a 5 buck discount which is actually quite astounding. Maybe this is simply indicating further US$ weakness, but the volumes are expected to remain pretty high. So the forward curve for coal isn’t showing appreciable danger of a big slowing and that ought to be a loud canary in the mine (no pun intended. Moreover the annual song and dance with the japanese indicates that the one year contract negotiations are going to be excellent.

Our rates are pretty high, possibly too high and they could come down a long way if needed.

We have tax cuts coming up which in a slowdown look like an accidental blessing.

Our exchange rate is pretty high and it could easily go lower in a slowdown very quickly.

The point I was making is that the international situation shouldn’t necessarily be as bad as a material domestic policy error such as tightening up the labor market at exactly the wrong time. So I fear a domestic policy mistake rather than just a slowdown internationally.

Your point though was pretty spot on in terms of having a questionable policy mix. Don’t you think that shows potent5ial problems could be home grown more so than sidewinders coming from overseas?

The real risk we have is that the consumer is highly leveraged, so I hope we don’t have a domestic policy mistake as that could dump a lot of cadavers on the road.

Although, I’m a bit more optimistic than John is on the intenational front (a mild US recession won’t affect us that much, but a severe recession might), tightening the labour market and raising interest rates when the economy is slowing down will be judged quite harshly, in retrospect, if there is a recession.

James – the link to the figure appears broken.