RBA should stop relying on outdated theory about inflation and ...

My economics teacher at Randwick Boys High was either well read or way ahead of his time.

But way back in 1974, Mr Geddes made a startling pronouncement in class one day.

There was a growing school of thought, he told us, that from now on full employment meant that about 5 per cent of the workforce would be out of a job.

Five per cent! It seemed like a rather large chunk of the workforce, given average unemployment had been just 2 per cent for more than 20 years. And a convenient, nice round number too. It was almost as though they had just made it up.

While he explained that, with the economy evolving, more people would be shifting jobs and temporarily sidelined, he didn't mention the perverse thinking behind this new push; that it was somehow desirable to have a large pool of idle workers. More on that later.

It is a theory that has taken hold in the world of economics despite mounting doubts about whether it works.

While it will play a key role in today's Reserve Bank of Australia decision to keep interest rates on hold, it will barely rate a mention in the accompanying RBA statement.

In short, the RBA would like more Australians to lose their jobs.

Governor Michele Bullock would never be as blunt as that, of course. And to her credit, she has batted away calls from a legion of vocal senior economists to push interest rates higher, to deliberately throw more workers on the scrap heap.

Many still firmly hold the view that, if you want to kill inflation, you need 5 per cent of workers sitting on their hands and they are annoyed the RBA hasn't heeded their calls for ever higher rates.

Instead, the RBA has targeted an upper-level jobless rate of 4.3 per cent.

When the figures last week for August arrived unchanged at 4.2 per cent, the disappointment was palpable.

Any chance of an imminent rate cut were discarded, for now.

Back in June, this little gem of central bank doublespeak was included in the governor's decision as to why interest rates were kept on hold.

"Conditions in the labour market eased further over the past month but remain tighter than is consistent with sustained full employment and inflation at target."

The Reserve Bank is under pressure to lift interest rates from some senior economists. (AAP: Bianca De Marchi)

Here's a plain English translation: "More people lost their jobs in the past month but not enough to ensure we have full employment and to keep inflation in check."

That's right. We need more people out of work to ensure we have full employment.

The theory behind all this emanates from New Zealand and a famous economist called Bill Phillips.

He came up with the idea, which he unsurprisingly called the Phillips Curve, that there was an inverse relationship between the jobs market and inflation.

If unemployment is low, inflation is likely to be high because firms have to pay higher wages to attract decent workers.

And when unemployment is high, inflation drops because fewer people can afford to buy things.

The mid-70s, when his theory really gained traction, was a time of great upheaval.

Global oil price shocks after the OPEC cartel decided it wasn't receiving a decent return for its product rocked developed nation economies, sending the US and the UK into recession.

Australia may have avoided recession but inflation pushed through 15 per cent and unemployment, which had averaged just 2 per cent during the previous 15 years, suddenly started to spike.

As living costs soared, industrial action exploded. Strikes became a daily event and relations between employers and unions became ever-more toxic.

The arrival of the Hawke-Keating governments in 1983, and the implementation of a series of accords, finally took the heat out of the situation.

One thing that went largely unnoticed through this period was that the Phillips Curve didn't work.

Inflation and unemployment together went into orbit for more than a decade and a half.

While they wouldn't say it this bluntly, central bankers are looking for the unemployment rate to climb. (ABC News: Michael Barnett)

From 15.4 per cent in 1974, inflation ended the 1980s at 7.3 per cent. Unemployment surged from about 2.5 per cent to almost 10 per cent during the same period before dropping to 6 per cent at the end of the 1980s. It quickly surged back to 10 per cent in the 1990s recession.

Despite that lack of correlation, economists locked in the theory. For central banks, including the RBA, it became an article of faith; if you want to control inflation, you have to sacrifice workers.

It's still deeply ingrained in their thinking.

To avoid openly discussing this, they came up with a code. It's called the NAIRU, the Non-Accelerating Inflationary Rate of Unemployment. That's the unemployment rate that will keep inflation in the 2-3 per cent target band.

It's a deliberately wonkish sounding acronym cleverly designed to avoid the obvious embarrassment of suggesting large numbers of Australians should be sacrificed for the greater good.

Astoundingly, no-one can actually tell you what the NAIRU is. That's because they simply don't know. For years, any time the jobless rate dropped to within earshot of 5 per cent, red lights would begin flashing.

The RBA is suggesting 4.3 per cent unemployment based on its forecasts. But in the years leading up to the pandemic, it became rubbery as inflation receded to dangerously low levels even though jobs numbers were incredibly strong. Again, the theory just didn't hold.

Former treasurer Josh Frydenberg conceded in 2021 that estimates of the NAIRU were wrong and Treasury had to lower it.

"As has been foreshadowed, they now estimate that the NAIRU sits between 4.5 and 5 per cent, lower than their previous estimate of 5 per cent," he said.

There's no doubt that the RBA, along with other big central banks, did a great job of keeping inflation in check once they gained independence from government back in the 1990s.

But they weren't alone in the battle. In fact, they may have simply ridden the outgoing tide.

Globalisation and the rise of China effectively lowered the price of consumer goods, electronics, heavy machinery, ships and automobiles year after year. Essentially, China was exporting lower inflation and higher unemployment, particularly in major industrial countries such as the US.

But there was another big change as well, particularly in Australia.

The Phillips Curve assumes workers can simply demand more money when unemployment is low. They can to an extent. But workers are no longer anywhere near as powerful as they once were.

In Australia, you have to ask permission from the courts to take industrial action. As a result, the number of industrial disputes has plummeted since the 1970s.

That destroys a key plank in Bill Phillips's theory and in the thinking at RBA headquarters in Martin Place.

Just look at what happened in the past two years. Wage rises in the past two years didn't cover price rises, resulting in a loss of real income for households.

That has been weighing heavily on economic growth as household consumption has slumped.

Inflation is on the wane. So, clearly, by definition, the current level of unemployment is already helping reduce inflation.

Month after month, RBA missives worry that "inflation expectations could become entrenched" without considering that workers have little power to do anything about it.

Maybe it's time to consign Bill Phillips's theory to the dustbin.