Inflation: small problem, so don't hit with sledgehammer

It’s an old expression, but a good one: out of the frying pan, into the fire. Less than two years ago we were told that, after having escaped recession for almost 30 years, the pandemic and our efforts to stop the virus spreading had plunged us into the deepest recession in almost a century.

Only a few months later we were told that, thanks to the massive sums that governments had spent protecting the incomes of workers and businesses during the lockdowns, the economy had “bounced back” from the recession and was growing more strongly than it had been before the pandemic arrived.

No sooner had the rate of unemployment leapt to 7.5 per cent than it began falling rapidly and is now, we learnt a fortnight ago, down to 3.5 per cent – its lowest since 1974.

You little beauty. At last, the economy’s going fine and we can get on with our lives without a care.

But, no. Suddenly, out of nowhere, a new and terrible problem has emerged. The rate of inflation is soaring. It’s sure to have done more soaring when we see the latest figures on Wednesday morning.

So worrying is soaring inflation that the Reserve Bank is having to jack up interest rates as fast as possible to stop the soaring. It’s such a worry, many in the financial markets believe, that it may prove necessary to put interest rates up so high they cause ... a recession.

Really? No, not really. There’s much talk of recession – and this week we’re likely to hear claims that the US has entered it – but if we go into recession just a few years after the last one, it will be because the Reserve Bank has been panicked into hitting the interest-rate brakes far harder than warranted.

As you know, since the mid-1990s the power to influence interest rates has shifted from the elected politicians to the unelected econocrats at our central bank. A convention has been established that government ministers must never comment on what the Reserve should or shouldn’t be doing about interest rates.

So last week Anthony Albanese, still on his PM’s P-plates, got into trouble for saying the Reserve’s bosses “need to be careful that they don’t overreach”.

Well, he shouldn’t be saying it, but there’s nothing to stop me saying it – because it needs to be said. The Reserve is under huge pressure from the financial markets to keep jacking up rates, but it must hold its nerve and do no more than necessary.

It’s important to understand that prices have risen a lot in all the advanced economies. They’ve risen not primarily for the usual reason – because economies have been “overheating”, with the demand for goods and services overtaking businesses’ ability to supply them – but for the less common reason that the pandemic has led to bottlenecks and other disruptions to supply.

To this main, pandemic problem has been added the effect of Russia’s invasion of Ukraine on oil and gas, and wheat and other foodstuffs.

The point is that these are essentially once-off price rises. Prices won’t keep rising for these reasons and, eventually, the supply disruptions will be solved and the Ukraine attack will end. Locally, the supply of meat and vegetables will get back to normal – until the next drought and flooding.

Increasing interest rates – which all the rich countries’ central banks are doing – can do nothing to end supply disruptions caused by the pandemic, end the Ukraine war or stop climate change.

All higher rates can do is reduce households’ ability to spend – particularly those households with big, recently acquired mortgages, and those facing higher rent.

The Reserve keeps reminding us that – because most of us were able to keep working, but not spending as much, during the lockdowns – households now have an extra $260 billion in bank accounts. But much of this is in mortgage redraw and offset accounts, and will be rapidly eaten up by higher interest rates.

Of course, the higher prices we’re paying for petrol, electricity, gas and food will themselves reduce our ability to spend on other things, independent of what’s happening to interest rates. It would be a different matter if we were all getting wage rises big enough to cover those price rises, but it’s clear we won’t be.

The main part of the inflation problem that's of our own making is the rise in the prices of newly built homes and building materials. This was caused by the combination of lower interest rates and special grants to home buyers hugely overstretching the housing industry. But higher interest rates and falling house prices will end that.

So, while it’s true we do need to get the official interest rate up from its lockdown emergency level of virtually zero to “more normal levels” of “at least 2.5 per cent”, it’s equally clear we don’t need to go any higher to ensure the inflation rate eventually falls back to the Reserve’s 2 to 3 per cent target range.

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THE STATE OF THE ECONOMY

Although most of us would like to think the pandemic is receding into the past and we can move on to other things, we’re starting to realise that it’s still with us and is still having a big effect not only on our health and our overstrained hospitals, but also on our economy. It’s still being greatly affected by the pandemic itself and by our response to the threat it poses to life and limb.

When the pandemic began in March 2020, federal and state governments closed our borders to travel, and locked down the national economy, so as to limit the spread of the virus. They ordered many retail businesses and forms of entertainment to close or severely limit their activities. People were required to stay in their homes and, if possible, work or study from home. Knowing this could cause much unemployment of workers, the government introduced the JobKeeper wage subsidy scheme to maintain the link between employers and their employees, even if they had little work for those employees to do. It had other spending programs to support the incomes of businesses and households, as well as particularly industries, such as housing. The first, national lockdown lasted only about six weeks, but then a second, longer lockdown became necessary for NSW, Victoria and the ACT in the middle of 2021.

Although many economists feared we had entered a severe recession, with the government spending huge sums to limit the effect on incomes the national economy bounced back strongly after the first lockdown and again after the second one. Real gross domestic product contracted heavily in the June quarter of 2020 and to a lesser extent in the September quarter of 2021, but ended up growing by 1.4 pc over the year to March 2021, and by 3.3 pc over the year to March 2022.

The strength of the economy’s bounceback can be seen in what happened to employment and unemployment. Total employment actually grew by about 60,000 over the year to March 2021, and by about 390,000 over the year to March 2022. This meant that, although the rate of unemployment shot up to 7.5 pc in July 2020, it had fallen back to 5.7 pc by March 2021 and to 3.9 pc in March 2022. By June, it had fallen to 3.5 pc, its lowest in 50 years. Because most of the new jobs created have been full-time, the rate of under-employment has also fallen considerably. There is a shortage of suitable labour, with the number of job vacancies now at record levels. Yet another sign of how “tight” the labour market is: the “participation rate” – that is, the proportion of the working-age population participating in the labour force either by working or actively seeking work – is at a record high of 66.8 pc.

Why is the jobs market so tight? Partly because of the massive economic stimulus applied to the economy by governments, but also because the closure of our borders for two years has cut off employers’ access to what you could call “imported labour”. So job vacancies that normally would have been filled by backbackers, overseas students and skilled workers on temporary visas have either had to go to locals, or go begging. Our borders have now been re-opened to foreign workers, so the labour market’s present tightness is temporary, but it’s likely to take more than several months for the inflow of foreign workers to return to normal.

As I’m sure you know, the pandemic has led to big changes in the settings of both fiscal policy and monetary policy. Those changes do much to explain where the economy is now and what the economic managers must do ensure we stay on the path of material prosperity.

Starting with fiscal policy, the former Morrison government had just got the budget back to balance when the pandemic arrived in early 2020. It’s decision to limit the spread of the virus by locking down the economy, while using the budget to protect the incomes of households and businesses, ended any prospect of returning the budget to surplus. Instead, the lockdowns caused a big fall in tax collections, while the spending and tax cuts to protect household and business incomes cause the budget to return to huge deficits, peaking at a record $134 billion (6.5 pc of GDP) in 2020-21, then falling to an expected $78 billion (3.4 pc) in the present financial year, 2022-23. Note that, even if the government had not decided to lockdown the economy while protecting incomes, the economy would still have slowed and the budget returned to deficit as many people took their own measures to protect themselves from the virus by avoiding crowded shops and venues and staying at home as much as possible. The government’s response to the pandemic and the huge budget deficits it led to added to its already-high level of public debt, causing the gross debt to rise to an expected almost $1 trillion (43 pc of GDP) by June 2023. Despite its own promises of further government spending and tax cuts, the new Albanese government will try to reduce prospective budget deficits and limit further growth in the debt in the budget it will announce in October.

Turning to monetary policy, low world interest rates and weak growth in our economy had the cash rate already down to 0.75 pc before the pandemic. In March 2020 the RBA cut the rate to 0.25 pc and, some months later, to 0.10 pc. It began engaging in unconventional monetary policy – “quantitative easing”, QE – by buying second-hand government bonds so as to reduce government and private sector interest rates on longer-term borrowing. Since it paid for these second-hand bonds merely by crediting the exchange settlement accounts of the banks it bought the bonds from, this had the effect of creating money. Note that the resulting increase in the RBA’s holdings of government bonds meant that about $350 billion of the government’s gross debt of nearly $1 trillion has been borrowed not from the public but from the central bank that is owned by the government.

The RBA’s most recent forecast is for real GDP to grow by a super-strong 4 pc this calendar year, but slow to a relatively weak 2 pc in 2023. But this prospect has been upset by the emergence of a new problem. For about six years before and during the pandemic, the problem was that the rate of inflation was too low, falling below the RBA’s 2 to 3 pc inflation target. But by the end of last year, 2021, the annual inflation rate had risen to 3.5 pc and by March 2022 it had risen to 5.1 pc. It’s expected to rise further over the rest of this year, reaching a peak of about 7 pc before starting to fall back slowly towards the target rate next year.

The first thing to note is that the rise in prices has been a global problem, with largely global causes. Inflation has risen in all the advanced economies, and by more than it has in Australia. In the US and many European countries, it’s up to about 10 pc, the highest rate in decades.

There are three main causes of this sudden reversal in inflation. Two of the three are “imported inflation” and all three involve problems and price rises coming from the supply side of the economy, rather than price rises caused by excessive demand. The first and most important is the major interruptions to global supply chains caused by the pandemic and, in particular, by the spending of locked-down households switching from services to goods. The increased demand for goods led to shortages of container ships and containers themselves, shortages of computer chips and many many other things, including timber and other building supplies. When the demand for goods exceeds their supply, business tend to increase their prices. These effects are temporary, however, and many supply bottlenecks are easing. But the problems China is having in coping with the pandemic suggest there may be further supply disruptions to come.

The second major global and imported source of higher prices is Russia’s invasion of Ukraine, which has caused major disruptions to the global markets for energy and food. But recently world oil, wheat and other commodity prices have fallen somewhat.

The third major, but little-noticed source of higher prices is also global and on the supply side: climate change. This is true even though its effects are specific to Australia. Restock of herds following the end of the most recent drought has seen beef prices rise by 12 pc over the year to March and by about 30 pc over the past three years. Lamb prices rose by 7 pc over the year to March and by 30 pc over the past four years. All the recent talk of paying $10 for an iceberg lettuce is a product of all the flooding in Queensland and NSW this year.

To these three causes the RBA adds a fourth factor, coming from the demand side of the economy: the strong demand for goods during the pandemic has allowed businesses to pass any rise in their costs on to customers, without fear of losing business. There has also been some increase in wage rates but, as yet, there is little sign employees have sufficient bargaining power to achieve wage rises of more than 3 pc or so, meaning wages are likely to continue falling in real terms.

In response to the rise in inflation, the RBA began a series of rate rates during the election campaign in May. In three months it has lifted the cash rate from 0.1 pc to 1.35pc, and is expected to continue raising it until it has reached “more normal levels” of at least 2.5 pc. It is moving the “stance” of monetary policy from the pandemic’s emergency levels of stimulus to a “neutral” stance – that is, a rate that’s neither expansionary nor contractionary. In other words, it is taking its foot off the monetary accelerator, not jamming on the brakes. Its goal is to ensure that excessive demand in the economy doesn’t cause temporary inflationary pressure coming from the economy’s supply side to become entrenched, rather than having inflation fall back to the 2 to 3 pc target range over the next year or two. It hopes to achieve this without causing a recession – which won’t be easy.

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