Friday, December 23, 2022

RBA warning: our supply-side problems have only just begun

In one of his last speeches for the year, Reserve Bank governor Dr Philip Lowe has issued a sobering warning. Even when we’ve got on top of the present inflation outbreak, the disruptions to supply we’ve struggled with this year are likely to be a recurring problem in the years ahead.

Economists think of the economy as having two sides. The supply side refers to our production of goods and services, whereas the demand side refers to our spending on those goods and services, partly for investment in new production capacity, but mainly for consumption by households.

Lowe notes that, until inflation raised its ugly head, the world had enjoyed about three decades in which there were few major “shocks” (sudden big disruptions) to the continuing production and supply of goods and services.

When something happens that disrupts supply, so that it can’t keep up with demand, prices jump – as we’ve seen this year with disruptions caused by the pandemic and its lockdowns, and with Russia’s attack on Ukraine.

What changes occurred over the three decades were mainly favourable: they involved increased supply of manufactured goods, in particular, which put gentle downward pressure on prices.

This made life easier for the world’s central banks. With the supply side behaving itself, they were able to keep their economies growing fairly steadily by using interest rates to manage demand. Put rates up to restrain spending and inflation; put rates down to encourage spending and employment.

The central banks were looking good because the one tool they have for influencing the economy – interest rates – was good for managing demand. Trouble is – and as we saw this year – managing demand is the only thing central banks and their interest rates can do.

When prices jump because of disruptions to supply, there’s nothing they can do to fix those disruptions and get supply back to keeping up with demand. All they can do is strangle demand until prices come down.

So, what’s got Lowe worried is his realisation that a lot of the problems headed our way will be shocks to supply.

“Looking forward, the supply side looks more challenging than it has been for many years” and is likely to have a bigger effect on inflation, making it jump more often.

Lowe sees four factors leading to more supply shocks. The first is “the reversal of globalisation”.

Over recent decades, international trade increased significantly relative to the size of the global economy, he says.

Production became increasingly integrated across borders, and this lowered costs and made supply very flexible. Australia was among the major beneficiaries of this.

Now, however, international trade is no longer growing faster than the global economy. “Trading blocs are emerging and there is a step back from closer integration,” he says. “Unfortunately, today barriers to trade and investment are more likely to be increased than removed.”

This will inevitably affect both the rise in standards of living and the prices of goods and services in global markets.

The second factor affecting the supply side is demographics. Until relatively recently, the working-age population of the advanced economies was steadily increasing. This was also true for China and Eastern Europe – both of which were being integrated into the global economy.

And the participation of women in the paid labour force was also rising rapidly. “The result was a substantial increase in the number of workers engaged in the global economy, and advances in technology made it easier to tap into this global labour force,” Lowe says.

So, there was a great increase in global supply. But this trend has turned and the working-age population is now declining, with the decline projected to accelerate. The proportion of the population who are either too young or too old to work is rising, meaning the supply of workers available to meet the demand for goods and services has diminished.

The third factor affecting the supply side is climate change. Over the past 20 years, the number of major floods across the world has doubled and the frequency of heatwaves and droughts has also increased.

This will keep getting worse.These extreme weather events disrupt production and so affect prices – as we know all too well in Australia. But as well as lifting fruit and vegetable prices (and meat prices after droughts break and herd rebuilding begins), extreme weather can disrupt mining production and transport and distribution.

The fourth factor affecting the supply side is related: the transition from fossil fuels to renewables. This involves junking our investment in coal mines, gas plants and power stations, and new investment in solar farms, wind farms, batteries and rooftop solar, as well as extensively rejigging the electricity network.

It’s not just that the required new capital investment will be huge, but that the transition from the old system to the new won’t happen without disruptions.

So, energy prices will be higher (to pay for the new capital investment) and more volatile when fossil-fuel supply stops before renewables supply is ready to fill the gap.

Lowe foresees the inflation rate becoming more unstable through two channels. First, shocks to supply that cause large and rapid changes in prices.

Second, the global supply curve becoming less “elastic” (less able to respond to increases in demand by quickly increasing supply) than it has been in the past decade.

Lowe says bravely that none of these developments would undermine the central banks’ ability to achieve their inflation target “on average” - that is, over a few years – though they would make the bankers’ job more complicated.

Well, maybe. As he reminds us, adverse supply shocks can have conflicting effects, increasing inflation while reducing output and employment. The Reserve can’t increase interest rates and reduce them at the same time.

As Lowe further observes, supply shocks “also have implications for other areas of economic policy”. Yes, competition policy, for instance.

My conclusion is that managing the economy can no longer be left largely to the central bankers.