terms of trade has created greater scope for non - inflationary wage increases. this is true, to the extent that the improvement is not merely transitory. but even if it is merely transitory, it keeps inflation from rising above target for a while, even if wage increases are well in excess of the level that is consistent with the target in the long run. another possible explanation is that the equilibrium real exchange rate is rising at present because of the improvement in terms of trade and the reduction of external debt, owing in part to the settlement of the failed banks ’ estates and the release and tying - up of offshore kronur. to the extent that this does not surface in a nominal currency appreciation, it will put temporary pressure on wages and prices. it seems to me that a number of signs indicate that all of these explanations apply to some degree. but the consequences for economic stability will be determined, among other things, by the weight of each one and by the response of monetary policy and other economic policies. in any case, it is clear that something has to give. as chart 1 shows, we are undergoing a period of several years during which unit labour costs are growing well in excess of the level that is consistent with the inflation target. at the same time, productivity growth is very weak. bis central bankers ’ speeches if the central bank ’ s most recent forecast materialises, the result will be as is shown in chart 2 : the real exchange rate and wage share will rise far above their historical averages, and the tension in the labour market will be amplified even further. but i consider it unlikely that this will be the outcome. either the adjustment will take place through some combination of higher inflation and higher unemployment, or positive shocks will provide some assistance ; for example, the improvement in terms of trade will be greater and more lasting, productivity growth will be stronger, and interest payments to abroad will be lower because of reduced external debt and improved credit ratings. it will be very interesting to see how things develop in the next few years. it would be imprudent, however, for economic policy and contingency planning to rely blindly on positive shocks. and then there is inflation. inflation has risen more slowly following the recent pay hikes than perhaps could have been expected in view of historical experience, and it is still well below target. this could be due in part to the additional scope provided by the favourable initial position of many firms and by the improvement in terms of trade. but the

ric battellino : the reserve bank of australia ’ s thinking on the economy over the past year address by mr ric battellino, deputy governor of the reserve bank of australia, to the economist ’ s bellwether series : australia, sydney, 23 august 2011. * * * over the past year, the australian economy has been subject to a number of strong, often countervailing, economic forces : strong demand for commodities, rising global inflation, global financial market instability, consumer caution, slower population growth and slow productivity growth. the economy has also been affected by severe weather events. today i would like to look back over the year and review how these forces have shaped the economy and the reserve bank ’ s thinking on monetary policy. if we start by casting our minds back a year ago, you will recall that the bank at that time was starting to contemplate whether it should move from a relatively neutral setting of monetary policy to one that was slightly restrictive. the global economy was growing at a solid pace, though with clear downside risks. domestically, a rebalancing in demand, from public to private spending, was starting to take place ; the outlook for business investment was particularly strong. employment was growing very quickly, unemployment had fallen back to just above 5 per cent, and inflation was forecast to reach the top end of the target range over the subsequent couple of years. the board ’ s assessment of these circumstances was that, if they continued and the economic outlook evolved as expected, there would be a case to raise interest rates a little at some point. however, the uncertainty in global markets, due to the spread of sovereign debt concerns beyond greece, was seen as posing downside risks to the global economy, and consequently to australia. also, the strong exchange rate and weak demand for credit pointed to financial conditions perhaps being somewhat tighter than might be indicated simply by reference to interest rates. these considerations were seen as reasons for caution and, in the event, the board held interest rates steady through to november 2010. by the november meeting, financial market volatility had declined and the chinese economy was continuing to grow strongly. earlier downside risks to global growth had diminished somewhat and it was becoming clear that global gdp would record a very strong increase for 2010 as a whole. domestically, employment had continued to grow very quickly. while there were significant differences in the performance of various sectors of the economy, overall it appeared that resource utilisation in the economy was tightening. the