Unbalanced economy a challenge for the RBA

Of course, we are where we are, and competitiveness of many industries has already been eroded.

There are many events which could trigger a major fall in the value of the Australian dollar. Whatever the precise cause, or mix of causes, a large fall in the dollar would create fresh dilemmas for the Reserve Bank.

In recent times, the strong dollar has kept traded goods inflation low. Low traded-goods inflation has co-existed with non-traded goods inflation of about 4 per cent. The net result has been overall goods and services inflation comfortably within the RBA's target zone.

But a large fall in the dollar would mean traded goods inflation would jump, and non-traded goods inflation would also rise more quickly.

The RBA might well find that its target "inflation zone" was unable to be achieved by modest increases of interest rates under official control.

The Reserve Bank struggled to find a good answer when the effects of financial deregulation destroyed its ability to achieve the "money growth projections" imposed by government from the mid-1970s to the mid-1980s.

The bank now, following a large fall in the value of the dollar, would have to at least suspend the inflation target, or exclude traded goods (assuming non-traded inflation was not too high for policy to reduce it quickly), risking a major loss of credibility.

Clearly Australia is heading into largely uncharted waters. A policy of realistic recognition and frank discussion of the challenges and the likely costs of different policies is badly needed and long overdue.

The Reserve Bank is on the horns of a major dilemma. What will it do? Probably sit pat for now but with a bias towards further cuts. Choosing the slippery slope.