How human psychology helps explain the resurgence of inflation

The beginning of wisdom in economics is to realise that models are models – an oversimplified version of a complicated reality. A picture of reality from a particular perspective.

I keep criticising economists for their excessive reliance on their basic, “neoclassical” model – in which everything turns on price, and prices are set by the rather mechanical interaction of supply and demand.

It’s not that the model doesn’t convey valuable insights – it does – but they’re often too simplified to explain the full story.

Sometimes I think Reserve Bank governor Dr Philip Lowe is like someone whose brain has been locked up in a neoclassical prison. But in his major speech on inflation two weeks ago, he showed he’d been thinking well outside the bars, looking at various models for a comprehensive explanation of how inflation could shoot up so quickly and unexpectedly.

He observed that another “element in the workhorse models of inflation is inflation expectations.” This relatively recent, more psychological addition to mainstream economics says that what businesses and unionised workers expect to happen to inflation tends to be self-fulfilling because they act on their expectations.

We’ve heard much about the risk of worsening inflation expectations, including from Lowe. It’s been the main justification offered for jacking up interest rates so high, so fast. But Lowe admitted it’s a weak argument.

“Inflation expectations have picked up a little, but...there is a high degree of confidence that inflation will return to target. This suggests that a pick-up in inflation expectations is not a primary driver of the sharp rise in inflation,” he said.

As Professor Ross Garnaut has observed - and recent Reserve research has confirmed – “the spectre of a virulent wage-price spiral comes from our memories and not current conditions”.

But, Lowe said, there’s something here that’s not easily captured in our standard models. That’s “the general inflation psychology in the community. By this, I mean the general willingness of businesses to see price increases and the willingness of the community to accept price increases.

“Prior to the pandemic, it was very difficult for a business person to stand in the public square and say they were putting their prices up. And a common theme from our liaison [regular interviews with business people] was that because most businesses had trouble putting their prices up, wage increases had to be kept modest. That was the mindset.”

Mindset? Mindset? That’s not a word you’ll find in any economics textbook. There’s no equation or diagram for mindsets.

Today, however, “business people are able to stand in the public square and say they are putting their prices up, and they can point to a number of reasons why.

"The community doesn’t like it, but there is a begrudging acceptance. And with prices rising, it is harder to resist bigger wage increases, especially in a tight labour market,” Lowe said.

“So, the psychology shifts. Or as the Bank for International Settlements put it in its recent annual report: when inflation is high, it becomes a coordinating mechanism for pricing decisions.

"In other words, people really start to pay attention to changes in costs and prices. The result can be faster and fuller pass-through of cost shocks and more frequent price and wage adjustments.

“There is some evidence that is already occurring, which is contributing to the strength of the pick-up in inflation,” Lowe added in his speech earlier this month.

To be fair, this is just the latest version of a thesis – a “model” – Lowe has been developing for years. And I think he’s on to a phenomenon which, when added to all the mechanistic, mathematised rules of the standard model, takes us a lot further in understanding what the hell’s been happening to the economy.

It’s taking the standard model but, contrary to its assumptions, accepting that, as the social animals that humans are, economic “agents” – whether consumers, bosses, workers or union secretaries – have a tendency to herding behaviour.

You can observe that in financial markets any day of the week. We feel comfortable when we’re doing what everyone else’s is doing; we feel uncomfortable when we’re running against the herd.

Anyone knows who has worked in business for a while – as many econocrats and academic economists haven’t – business behaviour is heavily influenced by fads and fashions. One role of sharemarket analysts is to punish companies that don’t conform to the fad of the moment.

The world’s economists spent much time between the global financial crisis and the pandemic trying to explain why all the rich economies had spent more than a decade caught in “secular stagnation” – a low-growth trap.

I think Lowe’s found a big piece of that puzzle. Business went through this weird period of years, when because no one else was putting up their prices, no one wanted to put up their prices.

The inflation rate fell below the Reserve’s target range, and stayed there for years. Businesses had no reason to invest much, so productivity improvement fell away, and economic growth was weak.

But then, along came the pandemic, lockdowns, huge budgetary and monetary stimulus, borders closed to immigrants, and finally a massive supply shock from the pandemic and the Ukraine war.

Suddenly, some big price rises are announced, the dam bursts and everyone – from big business to corner milk bars – starts putting up their prices. The spell has broken, and I doubt we’ll go back to the weird world we were in.

But the other side of the no-price-rises world was an obsession with using all means possible – legal or illegal – to cut labour costs. This greatly reinforced the low-growth trap we were caught in. But it was made possible also by the various developments that have robbed workers of their bargaining power.

It’s not yet clear whether the end of the self-imposed ban on price rises will be matched by an end to the ban on decent pay rises. If it isn’t, we’ll still be lost in the woods.

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Don't worry about inflation, the punters will be made to pay for it

Our sudden, shocking encounter with high inflation has brought to light a disturbing truth: we now have a dysfunctional economy, in which big business has gained too much power over the prices it can charge, while the nation’s households have lost what power they had to protecting their incomes from inflation.

It has also revealed the limitations and crudity of the main instrument we’ve used to manage the macro economy for the past 40 years: monetary policy – the manipulation of interest rates by the central bank.

We’ve been reminded that monetary policy can’t fix problems on the supply (production) side of the economy. Nor can it fix problems arising from the underlying structure of how the economy works.

All it can do is use interest rates to speed up or slow down the demand (spending) side of the economy. And even there, it has little direct effect on the spending of governments or on the investment spending of businesses.

Its control over interest rates gives it direct influence only on the spending of households. And, for the most part, that means spending that has to be done on borrowed money: buying a home. But also, renting a home some landlord has borrowed to buy.

Get it? The Reserve Bank of Australia’s governor’s power to manipulate interest rates largely boils down to influencing how much households spend on their biggest single item of spending: housing. Because no one wants to be homeless, using interest rates to increase the cost of housing leaves people with less to spend on everything else.

This means the governor has little direct influence over big business’s ability to take advantage of strong demand to widen its profit margins. He must get at businesses indirectly, via his power to reduce their customers’ ability to keep buying their products.

Get it? Households are the meat in the sandwich between the Reserve and big business (with small business using the cover of big business’s big price hikes to sneak up their own profit margins).

Join the dots, and you realise the Reserve’s plan to get inflation down quickly involves allowing a transfer of many billions from the pockets of households to the profits of big business.

On one hand, big business has been allowed to raise its prices by more than needed to cover the jump in its costs arising from the supply disruptions of the pandemic and the Ukraine war. On the other, the loss of union bargaining power means big business has had little trouble ensuring its wage bill rises at a much lower rate than retail prices have.

So, it’s households that are picking up the tab for the Reserve’s solution to the inflation problem. They’ll pay for it with higher mortgage interest rates and rents, and a fall in the value of their homes, but mainly by having their wages rise by a lot less than the rise in their cost of living.

The RBA’s unspoken game plan is to squeeze households until demand for goods and services has weakened to the point where big business decides that raising its prices to increase its profits would cost it so many sales that it would be left worse off.

It may even come to pass that households have been squeezed so badly big businesses’ sales start falling, and some of them decide that cutting their price to win back sales would leave them better off.

In economists’ notation, maximising profits – or minimising losses – is all about finding the best combination of “p” (price) and “q” (quantity demanded).

You don’t believe big businesses ever cut their prices? It’s common for them to “discount” their prices in ways that disguise their retreat, using special offers, holding sales, and otherwise allowing a gap between their advertised price and the price many customers actually pay.

But why would that nice mother’s boy Dr Philip Lowe, whose statutory duty is to ensure that monetary policy is directed to “the greatest advantage of the people of Australia”, impose so much pain on so many ordinary people, who played no part in causing the problem he’s grappling with?

Because, as all central bankers do, he sees keeping inflation low as his central responsibility. And he doesn’t see any other way to stop prices rising so rapidly. It’s a case study in just what a crude, inadequate and blunt instrument monetary policy is.

Lowe justifies his measures to reduce inflation quickly by saying this will avoid a recession. But let’s not kid ourselves. This massive transfer of income from households to business profits will deal a great blow to the economy.

After going nowhere much for almost a decade, real household disposable income is now expected to fall for two years in a row. And who knows if there’ll be a third.

Economists have made much of the extra saving households did during the pandemic. But during Lowe’s appearance before the parliamentary economics committee on Friday, it was revealed that about 80 per cent of that extra $270 billion in saving was done by the 40 per cent of households with the highest incomes. So, how much of it ends up being spent is open to question.

The likelihood that our measures to weaken household spending will lead to a recession must be very high.

Until Lowe’s remarks before the committee on Friday, his commentary on the causes and cure of inflation seemed terribly one-sided. The key to reducing inflation was ensuring wages didn’t rise by as much as prices had, so that rising inflation expectations wouldn’t lead to a wage-price spiral.

He warned that the higher wages rose, the higher he’d have to raise interest rates. He lectured the unions, saying they needed to be “flexible” in their wage demands. You could see this as giving an official blessing to businesses resisting union pressure and granting pay rises far lower than prices had risen.

Lowe could just as easily have lectured business to be “flexible” in passing on all the higher cost of their imported inputs, when these were expected to be temporary – but he didn’t. He’s always quoting what business people are saying to him, but never what union leaders say – perhaps because he never talks to them.

But on Friday he evened up the record. “It is also important to note that, to date, the stronger growth in wages has not been a major factor driving inflation higher,” he said. “Businesses, too, have a role in avoiding these damaging outcomes, by not using the higher inflation as cover for an increase in profit margins.”

That’s his first-ever admission that, when conditions allow, business has the market power to raise its prices by more than just its rising costs. Problem is, monetary policy’s only solution to this structural weakness – caused by inadequate competitive pressure – is to keep demand perpetually weak.

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Labor's 'plan' to fix the economy has three big bits missing

If you think the jobs summit was stage-managed, you’re right. Anthony Albanese & Co got the tick for policy changes they’d always wanted to make. But the two top-drawer economists who addressed the summit – Professor Ross Garnaut and Danielle Wood, boss of the Grattan Institute – proposed three other vital matters for the government’s to-do list, which it had better get on with if it’s to manage the economy successfully.

Both wanted action on competition policy, immigration policy and fiscal (budget) policy. All of these could play an important role in making the economy less inflation-prone, achieving and retaining full employment, improving our productivity and ensuring workers get their fair share of the proceeds.

The major element in our inflation problem that no one dares to name – certainly not Reserve Bank governor Dr Philip Lowe who, in a long speech about the problem last week, didn’t find time to mention it – is the pricing power that our oligopolised economy gives our big businesses.

Much Treasury research has found that Australia’s businesses lack “dynamism”. To be blunt, they’re fat and lazy. Wood reminds us that lower levels of dynamism and innovation have been linked to a lack of competitive pressure in the economy.

“In competitive markets, excess profits should be dissipated over time as new and innovative competitors enter. But increasingly in Australia and elsewhere, we have seen the biggest and most profitable firms remain largely untroubled by new competitors,” she says.

“While being relaxed and comfortable may be profitable, it is not good for Australia’s long-term economic prospects.”

So, what should Labor do about it? “Making sure that Australia’s competition laws are fit for purpose is part of the response ... The former head of the Australian Competition and Consumer Commission, Rod Sims, has argued that the current merger laws are failing to adequately protect competition. His warnings should prompt serious thought,” Wood says.

Garnaut agrees. He says we have to think about the increasing role of “economic rents” – the ability to earn profits exceeding those needed to keep you in the business. “Productivity is reduced and the profit share of [national] income increased by monopoly and oligopoly,” he says.

The answer? “Rod Sims has drawn attention to the increasing role of oligopoly in the Australian economy, and the competition policy reforms that would reduce it.”

The point for the government to note is that, if it leaves big business’s pricing power unchecked, but restores the unions’ bargaining power, that will be a recipe for a more inflation-prone economy – and a Reserve Bank using high interest rates to keep the economy comatose.

Both Garnaut and Wood gave the highest priority to urging a lasting return to full employment and the many social and economic benefits it would bring, if the jobs market was always about as tight as it is now.

But, as Garnaut says, full employment is hard work for employers. “Many prefer unemployment, with easy recruitment at lower wages.”

Which helps explain why they’re so desperate to get the immigration flood gates reopened and flowing. They talk about shortages of skilled labour but, in truth, they’re just as keen to have less-skilled labour. High immigration is just one of the instruments from their toolbox they’ve been using to keep their labour costs low, including the cost of training workers.

But we can’t keep our gates shut forever, so what should the government do to open up without losing the benefits of full employment (including a strong incentive to train our own youngsters)?

Garnaut says immigration is much more likely to raise, rather than lower, average real wages if it is focused on permanent migration of people with genuinely scarce and valuable skills that are bottlenecks to valuable Australian production, and cannot be provided by training Australians.

Wood says we need to fix “out-dated” skilled migration rules. “Targeting higher-wage migrants directly for both temporary and permanent skilled migration would improve the productivity of the migration system and the Australian workforce,” she says.

Which brings us to the budget. Wood says that although our response to the pandemic may now seem to have stimulated demand more than is helpful, these pressures will dissipate, “especially if the federal government and the central bank work in tandem to address strong demand, and do what is possible to boost supply”.

That’s her nice way of saying that, if the government fails to get its budget deficit down, the Reserve Bank will take interest rates higher than it would have. And she’s right, it will.

The deficit needs to come down despite Labor’s expensive – but welcome – promise to greatly increase the wage rates of the mainly female workers in aged care and other parts of the care economy.

How can this circle be squared? To Garnaut, the answer’s obvious. If the government has to do more and pay more – including on defence – it will just have to tax more.

He reminds us that “in the face of these immense budget challenges, total and federal and state taxation revenue, as a share of gross domestic product, is 5.7 percentage points lower than the developed-country average.”

And when it comes to what more the government could tax, Garnaut has some ideas. Disruption from the Russian invasion of Ukraine has given our fossil fuel companies record profits from higher coal and gas prices, while substantially lowering living standards by greatly increasing electricity prices.

Garnaut says the government shouldn’t kid itself that leaving this disparity unchallenged wouldn’t leave deep wounds in the public’s faith in government.

Introducing a tax on these windfall profits would be one solution, but I suspect he wants something more substantive. He says a significant part of the increase in the profit share of national income in recent years has come from mining.

One response would be for mine workers to get much higher wages. But, he says, miners are already paid much more than workers in other industries. So, the appropriate public policy response is a mineral rent tax – that is, a tax on the mining companies’ excess profits – which would share the benefits with all of us.

Finally, Garnaut rebukes those economists who rely on fancy calculations to tell them how low the unemployment rate can get before we have a problem with inflation. He says this is not an output from an econometric model, it’s “an observed reality”. That is, you have to suck it and see.

“Economics is less amenable than physics to definitive mathematical analysis because it is about people, whose responses to similar phenomena change over time. We build models in our minds or computers that fit observed reality at one point in time, and reality changes. Then we have to think harder about what’s going on.”

Economics is about the behaviour of people! Who knew?

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Jobs summit: shut up those playing the productivity three-card trick

Anthony Albanese and his ministers are keen to ensure this week’s jobs and skills summit doesn’t degenerate into the talk fest the opposition is predicting it will be. Well, one way to avoid much hot air is to shut up people playing the usual three-card trick on productivity.

The truth is there’s a lot of muddled and dishonest talk about the relationship between wages and productivity. Much of this comes from the employer lobby groups, which will spout any pseudo-economic nonsense that suits their goal of keeping wage growth as low as possible.

But they get too much comfort from econocrats who think that if you know what economics 101 teaches about how demand and supply interact, you know all you need to know about how all markets work, including the labour market.

As former top econocrat Dr Michael Keating, an economist specialising in the labour market, has explained, “the authorities’ model, which assumes perfect competition, constant returns to scale and neutral technological progress, implies that real wages can be expected to grow at the same rate as [labour] productivity, neither more nor less, making it look as if the collapse in productivity growth explains the collapse in wages growth”.

So when workers complain about the lack of growth in real wages, the employers’ professional apologists reply that real wages haven’t grown because the productivity of labour hasn’t improved. If only the unions would co-operate in efforts to improve productivity, wages would grow, as sure as night follows day.

But the supposed magical mechanism by which productivity improvement flows inexorably to real wages is refuted by the summary statistics quoted in Treasury’s issues paper for the summit. We’re told that, though productivity improvement has slowed, we’ve still achieved growth averaging 1 per cent a year since 2004.

But we’re also told that “real wages have grown by only 0.1 per cent a year over the past decade, and have declined substantially over the past year”. Not much automatic flow-through there.

Which brings us to another thing that’s being fudged in the present debate. You sometimes hear spruikers for the employers implying you need productivity improvement to justify even a rise in nominal wages.

But productivity is a “real” – after-inflation – concept. For the benefit from national productivity improvement to be shared fairly between capital and labour – employers and employees – it has to increase wages over and above inflation.

Here, however, is where we strike another difficulty. There used to be tripartite consensus – business, workers and government – that wages should always keep up with prices. Cuts in real wages were needed only to correct a period where real wage growth had been excessive – that is, exceeding productivity improvement.

Right now, however, the opposite is the case. Real wages were long falling short of what productivity improvement we were achieving before the present surge in prices left wage rates far behind. Even with the labour market so tight, workers simply haven’t had the industrial muscle to achieve wage rises commensurate with the leap in prices.

And now, while businesses show little restraint in passing their higher imported input costs through to higher retail prices, while adding a bit for luck, the great and good – read business and the econocrats – have agreed that the quickest and easiest way to get inflation down is for the nation’s households to pay the price.

A big fall in real wages squares the circle. Business has passed on its costs – and then some – and the economic managers have redeemed their reputations and got the inflation rate falling back. What’s not to like?

Well, we’ve solved the problem by allowing a big cut in real household income. It’s likely businesses will feel adverse effects as households see no choice but to tighten their belts. And I imagine some workers, consumers and voters will be pretty upset, concluding that the economy certainly isn’t being run for their benefit.

In effect, Treasury’s issues paper says forget the present disaster and look to the future. We can get real wages growing again – an election promise - as soon as we get productivity up.

Well, no we can’t. The paper’s claiming that, contrary to the experience of the past decade, improved productivity automatically flows through to real wages. And even if that were true, it assumes workers are innumerate, and won’t know that future real gains in wages must first make up for previous real losses. It’s the productivity three-card trick.

Meanwhile, business and the econocrats’ self-serving expedience, in deciding that the punters should pay for a problem they did nothing to cause, has created the climate for radical reform of the wage-fixing system: a return to industry bargaining.

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Welcome to the job, Treasurer. Rather you than me

Very occasionally, some poor misguided letter-writer suggests to my boss that I’d make a better treasurer than the incumbent. I’m flattered, of course, but it’s never been a job I’ve lusted after. Nor do I delude myself I’d be much good at it. And that goes double for the present incumbent, Jim Chalmers.

I wouldn’t want to be in his shoes (especially not with people like that grumpy old bugger Gittins offering a critique of my every move).

When, within days of taking up the job, Chalmers declared the budget situation was “dire”, people thought he was just softening us up. But I suspect it had finally dawned on him (with a little help from his new treasury advisers) just what an unhygienic sandwich he’d promised to eat: the more so because he’d played his own part in making such a meal of it.

Chalmers’ problem comes in two parts. First, he inherited an almighty mess from Scott Morrison and Josh Frydenberg. They hadn’t exactly tidied the place up before leaving.

Justifiably, they’d racked up huge additional government debt to tide us through the worst of the pandemic, and now the economy was growing strongly. But they were still looking at a decade or more of budget deficits continuing to increase the debt.

It was a problem they’d think about when and if they were re-elected. Meanwhile, nothing mattered more that avoiding doing anything that could cost them votes.

All this we knew before the election. What was less obvious were the many stopgap measures they’d used to hold back the growth in government spending, building up a dam that would inevitably burst.

The stopgaps included making oldies wait many months for a homecare package, making people wait months for a visa, keeping the unemployed below the poverty line and thinking of excuses to suspend their payments.

And that’s before you get to the various, hugely expensive problems with the National Disability Insurance Scheme – problems that can’t be solved by telling the disabled to like it or lump it.

The Morrison government’s projections of continuing budget deficits assume those dams will never overflow. Much of the deficit is explained by the continuing cost of the Morrison government’s already legislated stage-three tax cut in July 2024, which the Parliamentary Budget Office now estimates will have added almost a quarter of a trillion dollars to our deficit and debt by 2032-33.

The second element of Chalmers’ budget problem is that, as part of its small-target strategy for finally winning an election, Labor promised never to do anything anyone anywhere would ever dislike.

When it came to the budget, while banging on about our trillion-dollar debt, they painted themselves into a corner by promising not to do what they’d need to do to stop adding to it. Not to rescind the stage-three tax cut, nor do anything else to increase taxes apart from a tax on multinational companies. (Talk about pie in the sky: make the wicked foreigners pay their fair whack and all our problems are solved without any pain.)

In theory, eliminating the budget deficit is easy. Just slash government spending to fit. All you’d have to do is, say, suspend indexation of the age pension, or cut grants to the states’ public hospitals and schools (while taking care not to touch private hospitals and schools).

In practice, making cuts sufficient to fill the gap is politically impossible. It’s true the government is busy reviewing all their predecessor’s spending, looking for waste and extravagance. But all that’s likely to achieve is to make room for their own new spending promises.

As several former top econocrats have told me, what’s needed to eliminate the deficit is to increase tax collections by about 4 per cent of gross domestic product – about $90 billion a year. See what I mean about Labor boxing itself in?

One thing that wasn’t clear before the election was the full extent of our problem with inflation, even though the Reserve Bank did increase interest rates a fraction during the campaign.

It’s made the need to reduce the budget deficit more pressing because the more the government reduces its own stimulus of the economy, the less the Reserve has to increase interest rates to get inflation down.

And the less rates rise, the less the risk that – as has happened so often in the past – the Reserve’s efforts to reduce inflation send us into recession. One of the side-effects of recession would be to increase deficit and debt greatly.

After his “dire” remark, I expected to see Chalmers edging quietly towards a door marked Sorry About That, and preparing a Keynes-like speech about how “when the facts change, I change my promises”.

But so far, he seems still to be painting himself into the corner. Apparently, keeping promises, no matter how ill-judged and overtaken by events, is more important to Labor than managing the economy well or even avoiding becoming a one-term government.

I’d never seen Chalmers and his boss as martyrs to the cause of Unbroken Promises.

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Housing own goal worsens our inflation problem

A key part of the economic response to the pandemic was to rev up the housing industry. It’s boomed and now it’s busting. What’s been achieved? Mainly, a big, self-inflicted addition to our inflation problem.

That, and a lot of recent first-home buyers now getting their fingers burnt. Well done, guys.

It’s not a crime to be wise after the event. Indeed, it’s a crime not to be. As we all know, you learn more from your mistakes than your successes.

We have much to learn from our mishandling of the economic aspects of the pandemic. Because we had no experience of pandemics, our mistake was to treat the lockdowns as though they were just another recession. Turned out they’re very different.

Because downturns in home building and house prices often lead the economy into recession, then a recovery in home building leads it out, the managers of the macroeconomy assumed it would be the same this time.

The federal government offered HomeBuilder grants to people ordering new homes or major alterations. The state governments offered stamp duty concessions to first-home buyers, provided they were buying new homes.

But the doozy was the Reserve Bank’s decisions to cut the official interest rate from 0.75 per cent to 0.1 per cent, and then cut the base rate for 3- and 5-year fixed-rate mortgages.

By the end of last year, according to the Bureau of Statistics, the median house price in Sydney and Melbourne had jumped by more than 40 per cent. In the following quarter, it fell by 7 per cent in Sydney and 10 per cent in Melbourne. By all accounts, it has a lot further to fall.

Turning to building activity, we’ve seen a surge in the number of new private houses commenced per quarter, which jumped by two-thirds over the nine months to June 2021. Then it crashed over the following nine months, to be up only 14 per cent on where it was before the pandemic.

It’s no surprise commencements peaked in June 2021. Applications for the HomeBuilder grant closed 14 days into the quarter.

But to commence building a house is not necessarily to complete it a few months later. The real value of work done on new private houses per quarter rose by just 15 per cent over the nine months to June 2021. Nine months later, it was up 12 per cent on where it was before the pandemic.

For the most part, the home building industry kept working through the two big lockdowns. It seems that, between them, the nation’s macro managers took an industry that was plugging along well enough, revved it up enormously, but didn’t get it building all that many more houses, nor employing many more workers.

Perhaps it soon hit supply constraints – shortages of building materials and suitable labour. I don’t know if the industry was lobbying governments privately for special assistance, or whether it didn’t have to. Maybe pollies, federal and state, just instinctively rushed to its aid.

But I wonder if the builders didn’t particularly want to get much bigger. There are few industries more cyclical than home building. Builders are used to building activity going up and down and prices doing the same.

When demand is weak, they try to keep their team of workers and subbies together by cutting their prices, maybe even to below cost. Then, when demand is strong, they make up for it by charging all the market will bear.

It’s the height of neoclassical naivety to think it never crosses the mind of a “firm” existing outside the pages of a textbook that manipulating supply might be a profitable idea.

So maybe the builders found the thought of increasing their prices more attractive than the thought of building a bigger business to accommodate a temporary, policy-caused surge in demand.

They may have taken a lesson from those property developers with large holdings of undeveloped land on the fringes of big cities. Dr Cameron Murray, a research fellow in the Henry Halloran Trust at Sydney University, has demonstrated that the private land-bankers limit the regular release of land for development in a way that ensures the market’s never flooded and prices just keep rising.

So, back to our inflation problem. Whenever people say the recent huge surge in prices is caused largely by overseas disruptions to supply, which can’t be influenced by anything we do, and will eventually go away, the econocrats always reply that some price rises are the consequence of strong domestic demand.

That’s true. As I wrote last week, it seems clear many of our businesses – big and small – have used the cover of the big rises in the cost of their imported inputs to add a bit for luck as they pass them on to consumers.

But I saved for today the great sore thumb of excess demand adding to the price surge: the price of building a new home (excluding the cost of the land) or major renovations. This accounted for almost a third of the rise in the consumer price index in the June quarter, and jumped by more than 20 per cent over the year to June.

The price of newly built homes has a huge weight of almost 9 per cent in the CPI’s basket of goods and services, making it the highest-weighted single item in the basket. This implies that new house costs have added almost 2 percentage points of the total rise of 6.1 per cent.

When the econocrats worry about the domestic contribution to the price surge, they never admit how much of that problem has been caused by their own mishandling of the pandemic.

Indeed, when people argued that the main thing further cutting interest rates would achieve would be to increase house prices, the Reserve was unrepentant, arguing that raising house prices and demand for housing was one of the main “channels” through which lower rates lead to increased demand.

But the crazy thing is, this strange way of using the cost of a new dwelling to measure the cost of housing for home-buyers – which, I seem to recall, was introduced in 1998 after pressure from the Reserve – exaggerates the true cost for people with mortgages, especially at times like these.

Few people ever buy a new dwelling and, even if they do, rarely pay for it in cash rather borrowing the cost. This is one reason the bureau doesn’t regard the CPI as a good measure of the cost of living, but does publish separate living-cost indexes for certain types of households.

Ben Phillips, of the Centre for Economic Policy Research at the Australian National University, has used the bureau’s living-cost indexes to calculate that about 80 per cent of households had a living cost increase below the CPI’s rise of 6.1 per cent. The median (typical) increase over the past year was 4.7 per cent.

What trouble the econocrats get us into when they use housing as a macro managers’ plaything.

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Inflation psychology: firms charge what they can get away with

Economists think inflation is all about economics. What they don’t know is that it’s also about psychology. But Reserve Bank governor Dr Philip Lowe shows a glimmer of understanding when he refers not to “inflation expectations” but to “inflation psychology”.

Notorious for their “physics envy” – where the world works according to known and unchanging laws, so everything can be reduced to mathematical calculation – economists think changes in prices are determined by the interaction of the “laws” of supply and demand.

This is true, but far from the whole truth. Especially for the prices set in the jobs market – aka wages – where this simple “neoclassical” analysis almost always gives wrong answers.

Economists’ first attempt at a less mechanical approach to the relatively modern problem of inflation – a continuing rise in the general level of prices – came from Milton Friedman and another Nobel laureate’s realisation of the important role played by people’s expectations about what will happen to the inflation rate.

If it worsens significantly and this leads enough people to expect it to stay high or go higher, their expectations may lead to the higher rate becoming entrenched via a “wage-price spiral”.

That is, expectations of higher inflation tend to be self-fulfilling because people act on their expectations. If businesses expect higher price rises generally, they adjust their own prices accordingly. And workers and their unions adjust their own wage demands accordingly.

When last the rich world had a big inflation problem, in the second half of the 1970s and much of the ’80s, this theory seemed to work well, though it took years for expectations to worsen. Then it took years of keeping interest rates high and demand weak, and getting actual inflation down below 3 per cent, before expected inflation came back down.

The inflation target, of 2 to 3 per cent on average, was set in the mid-90s to help “anchor” expectations at an acceptable level.

All this is why the latest leap in inflation has led some economists to worry that, if expectations become “unanchored”, inflation may become entrenched at a much higher level.

This fear explains why many are anxious to use higher interest rates to get actual inflation back down ASAP. If falling real wages help to speed the process, so much the better.

Two small problems with this. For a start, there’s little evidence – either here or in the other rich economies – that expectations have moved up. Sensibly, everyone expects that, before too long, the inflation rate will go back to being a lot lower.

In the real world of price-setting by firms and workers, it takes a lot longer for expectations to shift prices than it does for prices in share and other financial markets to bounce around.

But the deeper reason worries about worsening expectations are misplaced is that, since this theory became so influential in the ’70s, the mechanism by which the expected inflation rate becomes the actual rate has broken down.

Businesses retain the ability to raise their prices when they decide to – and to discount those prices should they discover they’ve pushed it too far and are losing sales - but organised workers have largely lost their ability to force employers to grant higher pay rises.

If you doubt that, ask yourself why the number of days lost to strikes is now the tiniest fraction of what it was in the ’70s. We’ve seen a little strike action lately, but it’s coming almost wholly from workers in the public sector – the main part of the workforce that’s still heavily unionised.

But the breakdown of the inflation-expectations theory and the “wage-price spiral” as explanations of the relatively modern phenomenon of inflation – a continuing rise in the general level of prices – leaves us looking elsewhere for explanations.

A big part of it is the message those economists who specialise in studying competition have to give financial economists such as Lowe: you don’t seem to realise that our modern oligopolised economy gives many big businesses a lot of power over the prices they’re able to charge.

Oligopoly is about the few huge firms dominating a particular market reaching a tacit agreement to keep prices high and stable, and limit their competition for market-share to non-price areas such as product differentiation and marketing.

As former competition czar Rod Sims has pointed out, this greatly reduces the ability of higher interest rates to influence prices in many big slabs of the economy.

But if many big businesses can improve their profitability by deciding to raise their prices, why did they wait until only a year ago to decide to start whacking up them up? Because it ain’t that simple.

All firms would like to raise their prices all the time. What stops them is the knowledge that they can’t charge more than “what the market will bear”. They worry about two things: what will my competitors do? And what will my customers do?

When there’s a big rise in input costs, the knowledge that all my competitors are facing the same cost increase gives me confidence we’ll all be passing it through to the customer at the same time.

That’s why it was the sudden, large and widespread increase in the cost of imported inputs caused by the pandemic and the Ukraine war that started the latest bout of prices rises at the retail level.

But, as Lowe keeps saying, the supply chain cost increases don’t explain all the rise in retail prices. He makes the obvious point that firms find it easier to raise their prices at a time when demand is strong and people are spending. His interest-rate rises are intended to stop demand being so strong and conducive to price rises.

But the less obvious point – especially to people mesmerised by the neoclassical way of thinking – is the role of psychology. I’ve got a great justification for increasing my prices, but no one’s counting. If my costs have risen by 5 per cent, but I increase my prices by 6 per cent, who’s to know?

Sims reminds us that this is just the way firms with pricing power behave. They raise their prices and profits in ways that aren’t easy for their customers to notice.

That covers big business. In the main, small businesses don’t have much pricing power. But “what the market will bear” is greater when the media has spent months softening up their customers with incessant talk about inflation and how high prices will go.

Lowe can’t say it, but it’s not uncooperative workers that are his problem, it’s businesses using the chance to slip in a little extra for themselves.

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Our hidden inflation problem: business has too much pricing power

Why is Reserve Bank governor Dr Philip Lowe so worried about getting inflation down when so much of the rise in prices comes from foreign supply constraints that will eventually go away, and so much of the rise won’t be passed on to workers in higher wages?

Because what he can’t admit is that inflation won’t fall back to the target range of 2 to 3 per cent until the nation’s businesses decide to moderate their price rises. And they’re not likely to do that until those rises reach the point where they’re driving away customers.

It’s said that using monetary policy (higher interest rates) to control inflation is a “blunt instrument”. The only way to discourage businesses from raising their prices is to get to their customers’ wallets - by cutting real wages, increasing mortgage payments and having falling house prices make them feel less wealthy.

When explaining problems in the economy, economists use two favourite analytical tools. First, determine how much of the problem is coming from the supply (production) side of the economy, and how much from the demand (spending) side.

Second, determine whether the problem is “cyclical” or “structural”. That is, has it been caused by the temporary ups and downs of the business cycle, or by longer-lasting changes in the economy’s structure – the way it works.

I’ve argued that most of the surge in prices has come from the supply side: a horrible coincidence of supply disruptions caused by the pandemic, the Ukraine war, and even climate change.

This matters because monetary policy can do nothing to fix disruptions to supply. All it can ever do is batter down demand.

It’s true, however, that this main, supply-side problem has been worsened by the effect of strong, government-stimulated demand for goods as services.

As for the cyclical-versus-structural distinction, it’s relevant because, as Lowe never tires of reminding us, monetary policy is capable of dealing only with cyclical problems. Its role is to smooth the ups and downs in demand as the economy moves through the business cycle.

But here’s the problem: higher interest rates aren’t working to reduce inflation the way they used to because of changes in the structure of the economy.

In particular, employees and their unions now have less power to insist on wage rises sufficient to keep up with price rises than they did when last we had a big inflation problem. But big business now has more power to raise its prices.

Partly because globalisation has moved much manufacturing from the high-wage advanced economies to China and other low-wage economies, and partly because of the decentralisation and deregulation of wage-fixing and the decline in union membership, most workers pretty much have to accept whatever inadequate pay rise their chief executive (or premier) chooses to give them.

This is why all the concern about inflation expectations becoming “unanchored” is so silly. Businesses have the power to act on their expectations of higher inflation, but workers no longer do.

This is why the rate of unemployment can fall far below what economists, using data going back decades, estimate to be the NAIRU - “non-accelerating-inflation” rate of unemployment - without wage inflation accelerating.

When thinking about inflation, macroeconomists – including Lowe, I suspect - often assume our markets are competitive, and that the markets for all goods and services are equally competitive.

But as Rod Sims, former chair of the Australian Competition and Consumer Commission, and now a professor at the Australian National University, has written, markets in Australia are generally far from strongly competitive.

“Many sectors ... are dominated by just a few firms – think beer, groceries, energy and telecommunications retailing, resources, elements of the digital economy, banking and many others,” Sims says.

“This means the dominant firms have some degree of market power. That is, they can set prices at higher levels knowing competitors are unlikely to undercut them and take market share from them.

“When there is high inflation, dominant firms often realise they can increase prices above any cost rises because consumers will be more accepting of this. They will often do this subtly over time.”

In concentrated markets, firms can also easily see the effects on their few competitors, and they can watch and follow each other’s behaviour. They are confident that none will break ranks on price rises because there are benefits to be had by all.

Firms with market and pricing power are also less likely to restrain prices in response to interest rate rises, Sims says. This is because it’s not competition, but dominant-firm behaviour, that’s driving pricing decisions.

As well, market power is usually associated with reduced production capacity. How often do we see reductions in combined capacity following a merger of two competitors? When demand increases, there’s then less capacity available to serve it, so we see prices rise more than they otherwise would have.

What all this means is that it may take longer for interest rates to work to slow inflation, so patience may be needed rather than further increases. And, Sims says, there could be a role for publicly exposing high margins, to put pressure on to reduce them.

Another point he makes is that this inflation owes much to price shocks in the key, highly regulated gas and electricity industries. In these cases, the best answer is to make their regulation more anti-inflationary, not just jack up interest rates further.

The micro-economic reforms of the Hawke-Keating government have made our economy much less inflation-prone than it was in the days when inflation was last a major problem.

Meanwhile, however, we’ve allowed the pricing power of big firms to grow as successive governments of both colours have resisted pressure from people like Sims to tighten our merger law, and state governments have maximised the sale price of their electricity businesses by selling them to business interests intent on turning the national electricity market into a three-firm vertically integrated oligopoly. Well done, guys.

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Fixing inflation isn't hard. Returning to healthy growth is

Despite any impression you’ve gained, fixing inflation isn’t the end game. It’s getting the economy back to strong, non-inflationary growth. But I’m not sure present policies will get us there.

The financial markets and the news media have one big thing in common: they view the economy and its problems one day at a time, which leaves them terribly short-sighted.

Less than two years ago, they thought we were caught in the deepest recession since the 1930s. By the end of last year, they thought the economy had taken off like a rocket. Now they think inflation will destroy us unless we kill it immediately.

For those of us who like to put developments in context, however, life isn’t that disjointed. The day-at-a-time brigade has long forgotten that, before the pandemic arrived, the big problem was what the Americans called “secular stagnation” and I preferred calling a low-growth trap.

In a recent thoughtful and informative speech, Treasury secretary Dr Steven Kennedy observed that the pandemic “followed a period of lacklustre growth and low inflation”. (It was so low the Reserve Bank spent years trying to get inflation up to the target range, but failing. Businesses didn’t want to raise wages – or prices.)

So, Kennedy said, “when assessing the policy decisions made during the pandemic there was an additional consideration for policymakers in wanting to not just return to the pre-pandemic situation, but to surpass it.”

One economist who shares this longer perspective is ANZ Bank’s Richard Yetsenga. He describes the 2010s as our “horrendum decennium” where unemployment and underemployment were relatively high, consumer spending relatively weak and business had plenty of idle production capacity.

He reminds us that real average earnings per worker in 2020 hadn’t budged since 2012. “The resulting weakness in consumer demand meant that ‘need’ – the most critical ingredient [for] business investment – was missing,” he says. “Excess demand, and the resulting lack of production capacity, is a pre-condition of investment.”

See how we were caught in a low-growth trap? Weak growth leads to low business investment, which leads to little productivity improvement, which leads to more weak growth.

During the Dreadful Decade, the prevailing view among policymakers was that high unemployment was preferable to high inflation, which might become entrenched. So, unemployment was left high, to keep inflation low.

Yetsenga says this decision to entrench relatively high unemployment was a mistake. “Unemployment, underemployment and the inequality they contribute to, all affect macroeconomic outcomes [adversely]“.

“Those on higher incomes tend to save more, reducing consumption, but those on lower incomes tend to borrow more. Inequality, in other words, tends to lower economic growth and exacerbate financial vulnerability.”

Even so, Yetsenga is optimistic. The policy response to the pandemic has “changed the baseline” and we’re in the process of escaping the low-growth trap.

Unemployment is at its lowest in five decades and underemployment has fallen significantly. Real consumer spending is 9 per cent above pre-pandemic levels, and businesses’ capacity utilisation has been restored to high levels not seen since before the global financial crisis.

As a result, planned spending on business investment in the year ahead is about the highest in nearly three decades.

Yetsenga says the Reserve would like some of the rise in the rate of inflation to be permanent. “If monetary policy can deliver [annual] inflation of 2.5 per cent over time, rather than the 1.5 to 2 per cent that characterised the pre-pandemic period, it’s not just the rate of inflation that will be different.

“We should expect the ‘real’ side of the economy to have improved as well: more demand, more employment and more investment.”

“The role of wages in sustaining higher inflation is well known, but wage growth doesn’t occur in a vacuum. To employ more people, give more hours to those working part-time, and raise wage growth, business needs to see demand strong enough to pay for the labour.

“Some of the additional labour spend will be passed on to higher selling prices. The need to invest in more labour is likely to go hand-in-hand with more capital investment.”

I think Yetsenga makes some important points. First, the policy of keeping unemployment high so that inflation will be low has come at a price to growth and contributed to the low-growth trap.

Second, inequality isn’t just about fairness. Economists in the international agencies are discovering that it causes lower growth. So, the policy of ignoring high and rising inequality has also contributed to the low-growth trap.

Third, the idea that we can’t get higher economic growth until we get more productivity improvement has got the “direction of causation” the wrong way around. We won’t get much productivity improvement until we bring about more growth.

Despite all this, I don’t share Yetsenga’s optimism that the shock of the pandemic, and the econocrats’ switch to what I call Plan B – to use additional fiscal stimulus in the 2021 budget to get us much closer to full employment, as a last-ditch attempt to get wage rates growing faster than 2 or 2.5 per cent a year – will be sufficient to bust us out of the low-growth trap.

Yetsenga’s emphasis is on boosting household income by making it easier for households to increase their income by supplying more hours of work. He says little about households’ ability to protect and increase their wage income in real terms.

Another consequence of the pandemic period is the collapse of the consensus view that wages should at least rise in line with prices. Real wages should fall only to correct a period when real wage growth has been excessive.

But so panicked have the econocrats and the new Labor government been by a sudden sharp rise in prices (the frightening size of which is owed almost wholly to a coincidence of temporary, overseas supply disruptions) that they’re looking the other way while, according to the Reserve’s latest forecasts, real wages will fall for three calendar years in a row.

Since it’s the easiest and quickest way of getting inflation down, they’re looking the other way while the nation’s employers – government and business - short-change their workers by a cumulative 6.5 per cent.

This makes a mockery of all the happy assurances that, by some magical economic mechanism, improvements in the productivity of labour flow through to workers as increases in their real wage.

Sorry, I won’t believe we’ve escaped the low-growth trap until I see that, as well as employing more workers, businesses are also paying them a reasonable wage.

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We're struggling with inflation because we misread the pandemic

It’s an understandable error – and I’m as guilty of it as anyone – but it’s now clear governments and their econocrats misunderstood and mishandled the pandemic from the start. Trouble is, they’re now misreading the pandemic’s inflation phase at the risk of a recession.

The amateurish way governments, central banks and economists have sought to respond to the pandemic is understandable because this is the first pandemic the world’s experienced in 100 years.

But it’s important we understand what we’ve got wrong, so we don’t compound our errors in the inflation phase, and so we’ll know how to handle the next pandemic - which will surely arrive in a lot less than 100 years.

In a nutshell, what we’ve done wrong is to treat the pandemic as though it’s a problem with the demand (or spending) side of the economy, when it’s always been a problem with the supply (or production) side.

We’ve done so because the whole theory and practice of “managing” the macroeconomy has always focused on “demand management”.

We’re trying to smooth the economy’s path through the ups and downs of the business cycle, so as to achieve low unemployment on one hand and low inflation on the other.

When demand (spending by households, businesses and governments) is too weak, thus increasing unemployment, we “stimulate” it by cutting interest rates, cutting taxes or increasing government spending. When demand is too strong, thus adding to inflation, we slow it down by raising interest rates, increasing taxes or cutting government spending.

When the pandemic arrived in early 2020, we sought to limit the spread of the virus by closing our borders to travel, ordering many businesses to close their doors and ordering people to leave their homes as little as possible, including by working or studying from home.

So, the economy is rolling on normally until governments suddenly order us to lock down. Obviously, this will involve many people losing their jobs and many businesses losing sales. It will be a government-ordered recession.

Since it’s government-ordered, however, governments know they have an obligation to provide workers and businesses with income to offset their losses. Fearing a prolonged recession, governments spend huge sums and the Reserve Bank cuts the official interest rate to almost zero.

Get it? This was a government-ordered restriction of the supply of goods and services, but governments responded as though it was just a standard recession where demand had fallen below the economy’s capacity to produce goods and services and needed an almighty boost to get it back up and running.

The rate of unemployment shot up to 7.5 per cent, but the national lockdown was lifted after only a month or two. As soon it was, everyone – most of whom had lost little in the way of income – started spending like mad, trying to catch up.

Unemployment started falling rapidly and – particularly because the pandemic had closed our borders to all “imported labour” for two years – ended up falling to its lowest rate since 1974.

So, everything in the garden’s now lovely until, suddenly, we find inflation shooting up to 6.1 per cent and headed higher.

What do we do? What we always do: start jacking up interest rates to discourage borrowing and spending. When demand for goods and services runs faster than business’s capacity to supply them, this puts upward pressure on prices. But when demand weakens, this puts downward pressure on prices.

One small problem. The basic cause of our higher prices isn’t excess demand, it’s a fall in supply. The main cause is disruption to the supply of many goods, caused by the pandemic. To this is added the reduced supply of oil and gas and foodstuffs caused by Russia’s attack on Ukraine. At home, meat and vegetable prices are way up because of the end of the drought and then all the flooding.

Get it? Once again, we’ve taken a problem on the supply side of the economy and tried to fix it as though it’s a problem with demand.

Because the pandemic-caused disruptions to supply are temporary, the Ukraine war will end eventually, and production of meat and veg will recover until climate change’s next blow, we’re talking essentially about prices that won’t keep rising quarter after quarter and eventually should fall back. So surely, we should all just be patient and wait for prices to return to normal.

Why then are the financial markets and the econocrats so worried that prices will keep rising, we’ll be caught up in a “wage-price spiral” and the inflation rate will stay far too high?

Short answer: because of our original error in deciding that a temporary government-ordered partial cessation of supply should be treated like the usual recession, where demand is flat on its back and needs massive stimulus if the recession isn’t to drag on for years.

If we’d only known, disruptions to supply were an inevitable occurrence as the pandemic eased. What no one foresaw was everyone cooped up in their homes, still receiving plenty of income, but unable to spend it on anything that involved leaving home.

It was the advent of the internet that allowed so many of us to keep working or studying from home. And it was the internet that allowed us to keep spending, but on goods rather than services. It’s the huge temporary switch from buying services to buying goods that’s done so much to cause shortages in the supply of many goods.

But it’s our misdiagnosis of the “coronacession” – propping up workers and industries far more than they needed to be – that’s left us with demand so strong it’s too easy for businesses to get away with slipping in price increases that have nothing to do with supply shortages.

Now all we need to complete our error is to overreact to the price rises and tighten up so hard we really do have an old-style recession.

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The inflation fix: protect profits, hit workers and consumers

There’s a longstanding but unacknowledged – and often unnoticed – bias in mainstream commentary on the state of the economy. We dwell on problems created by governments or greedy workers and their interfering unions, but never entertain the thought that the behaviour of business could be part of the problem.

This ubiquitous pro-business bias – reinforced daily by the national press – is easily seen in the debate on how worried we should be about inflation, and in the instant attraction to the notion that continuing to cut real wages is central to getting inflation back under control. This is being pushed by the econocrats, and last week’s economic statement from Treasurer Jim Chalmers reveals it’s been swallowed by the new Labor government.

I’ve been arguing strongly that the primary source of the huge price rises we’ve seen is quite different to what we’re used to. It’s blockages in the supply of goods, caused by a perfect storm of global problems: the pandemic, the war in Ukraine and even climate change’s effect on meat and vegetable prices.

Since monetary policy can do nothing to fix supply problems, we should be patient and wait for these once-off, temporary issues to resolve themselves. The econocrats’ reply is that, though most price rises come from deficient supply, some come from strong demand – and they’re right.

Although more than half the 1.8 per cent rise in consumer prices in the June quarter came from just three categories – food, petrol and home-building costs – it’s also true there were increases in a high proportion of categories.

The glaring example of price rises caused by strong demand is the cost of building new homes. Although there have been shortages of imported building materials, it’s clear that hugely excessive stimulus – from interest rates and the budget – has led to an industry that hasn’t had a hope of keeping up with the government-caused surge in demand for new homes. It’s done what it always does: used the opportunity to jack up prices.

But as for a more general effect of strong demand on prices, what you don’t see in the figures is any sign it’s high wages that are prompting businesses to raise their prices. Almost 80 per cent of the rise in prices over the year to June came from the price of goods rather than services. That’s despite goods’ share of total production and employment being about 20 per cent.

This – along with direct measures of wage growth - says it’s not soaring labour costs that have caused so many businesses to raise their prices. Rather, strong demand for their product has allowed them to pass on, rather than absorb, the higher cost of imported inputs – and, probably, fatten their profit margins while they’re at it.

Take the amazing 7 per cent increase in furniture prices during the quarter. We’re told this is explained by higher freight costs. Really? I can’t believe it.

Nor can I believe that months of unrelenting media stories about prices rising here, there and everywhere – including an open mic for business lobbyists to exaggerate the need for price rises – haven’t made it easier for businesses everywhere to raise their prices without fear of pushback from customers.

But whenever inflation worsens, the economists’ accusing fingers point not to business but to the workers. No one ever says businesses should show more restraint, they do say the only way to fix the problem is for workers to take a real-wage haircut.

There’s no better evidence of the economics profession’s pro-business bias than its studious avoidance of mentioning the way the profits share of national income keeps rising and the wages share keeps falling.

In truth, the story’s not as simple as it looks, but it seems to have occurred to no mainstream economist that what may be happening is business using the cover of the supply-side disruptions to effect a huge transfer of income from labour to capital.

Allowing real wages to fall significantly for three years in a row – as Chalmers’ new forecasts say they will – would certainly be the quickest and easiest way to lower inflation, but do the econocrats really imagine this would leave the economy hale and hearty?

Yet another sign of economists’ pro-business bias is that so few of them know much – or even think they need to know much – about how wages are fixed in the real world. Hence all the silliness we’re hearing about the risk of lifting inflation expectations. Can’t happen when workers lack bargaining power.

You’d think an understanding of wage-fixing is something a Labor government could bring to the table. But no. All we’re getting from Chalmers is that we need to cut real wages so we can increase them later. Yeah, sure.

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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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Why interest rates are going up, and won't be coming down

It’s time we had a serious talk about interest rates. And, while we’re at it, inflation. Someone in my job knows it’s time to talk turkey when the man in charge of rates, Reserve Bank governor Dr Philip Lowe, decides to go on the ABC’s 7.30 program to talk about both.

There’s much to talk about. Why are interest rates of such interest to so many (sorry)? Why do some people hate them going up and some love it? How do interest rates and the inflation rate fit together? Why do central banks such as our Reserve keep moving them up and down? When rates go up, they normally come back down – so why won't that happen this time?

Starting with the basics, interest is the price or fee that someone who wants to borrow money for a period has to pay to someone who has money they’re prepared to lend – for a fee.

Legally, the “person” you’ve borrowed from is usually a bank, while the person with savings to lend deposits them with a bank. But economists see banks as just “intermediaries” that bring borrowers on one side together with ordinary savers on the other.

The bank charges borrowers a higher interest rate than it pays its depositors. The difference reflects the bank’s reward for bringing the two sides together, but also the risk the bank is running that the borrower won’t repay the debt, leaving the bank liable to repay the depositor.

You see from this that interest is an expense to borrowers, but income to savers. This is why there’s so much arguing over interest rates. Borrowers hate to see them rise, but savers hate to see them fall. (The media conceal this two-sided relationship by almost always treating rate rises as bad.)

Now we get to inflation. Economists think of interest rates as having two components. The first is the compensation that the borrower must pay the saver for the loss in the purchasing power of their money while it’s in the borrower’s hands. The second part is the “real” or after-inflation interest rate that the borrower must pay the saver for giving up the use of their own money for a period.

This implies that the level of interest rates should roughly rise and fall in line with the ups and downs in the rate of inflation – the annual rate at which the prices consumers pay for goods and services (but not for assets such as shares or houses) are rising.

This explains why, when the inflation rate was way above 5 per cent throughout the 1970s and ’80s, interest rates were far higher than they’ve been since.

Now it gets tricky. Central banks have the ability to control variable interest rates by manipulating what’s known confusingly as the “overnight cash rate”. This “official” interest rate forms the base for all the other (higher) interest rates we pay or receive.

The Reserve Bank uses its control over this base interest rate to smooth the ups and downs in the economy, trying to keep both inflation and unemployment low.

When it thinks our demand for goods and services is too weak and is worsening unemployment, it cuts interest rates to encourage borrowing and spending. When it thinks our demand is too strong and is worsening inflation, it raises interest rates to discourage borrowing and spending.

The pandemic and the consequent “coronacession” caused the Reserve (and all the other rich-country central banks) to cut the official interest rate almost to zero.

The economy has bounced back from the lockdowns and is now growing strongly, with very low unemployment and many vacant jobs. But now we’ve been hit by big price rises from overseas, the result of supply bottlenecks caused by the pandemic and a leap in oil and gas prices caused by the war on Ukraine, plus the effect of climate change on local meat and vegetable prices.

As Lowe explained to Leigh Sales on 7.30, these are once-only price rises and, although he expects the inflation rate to reach 7 per cent by the end of this year, it should then start falling back toward the Reserve’s target inflation rate of 2 to 3 per cent.

His worry is that the economy’s capacity to produce all the goods and services being demanded is close to running out – and already has in housing and construction. This raises the risk that the rate of growth in prices won’t fall back as soon as it should.

This is why Lowe’s started raising the official interest rate from its pandemic “emergency setting” near zero – zero! – to a “more normal setting”. Such as? To more like 2.5 per cent, he told Sales.

Why 2.5 per cent? Because that’s the mid-point of his inflation target.

Get it? Interest rates are supposed to cover expected inflation plus a bit more. Once Lowe’s able to get them back up to that level without causing a recession, they won’t be coming back down until the next pandemic-sized emergency.

A base interest rate of zero was never going to be the new normal. The nation’s saving grandparents would never cop it.

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Inflation: workers being unreasonable, or bosses on the make?

When you think about it clearly, the case for minimum award wages to be raised by 5.1 per cent is open-and-shut. So is the case for all workers to get the same. This wouldn’t stop the rate of inflation from falling back towards the Reserve Bank’s 2 to 3 per cent target zone.

But if, as seems likely, the nation’s employers contrive to ensure that this opportunity is used to continue and deepen the existing fall in real wages, the nation’s businesses will have shot themselves in the foot.

What, in their short-sightedness, they fondly imagined was a chance to increase their profits, would backfire as this blow to households’ chief source of income, crimped those households’ ability to increase or even maintain their spending on all the things businesses want to sell them.

The recovery from the “coronacession” would falter as households’ pool of savings left from the lockdowns was quickly used up, and their declining confidence in the future sapped their willingness to run down their savings any further.

Should the economy slow or even contract, unemployment could rise and the hoped-for gain in profits would be lost. Cheating your customers ain’t a smart business plan.

Such short-sighted thinking by businesses involves a “fallacy of composition” common in macro-economics: what seems “rational” behaviour by an individual firm doesn’t make sense for firms as a whole. It’s a form of “free-riding”: it won’t matter if I screw my workers because all the other businesses won’t screw theirs.

But back to wages. If all workers got a 5.1 per cent pay rise to compensate them for the 5.1 per cent rise in consumer prices over the year to March, thus preserving their wage’s purchasing power, surely that means the inflation rate would stay at 5.1 per cent?

Firms would have to raise their prices by 5.1 per cent. But many small businesses wouldn’t be able to afford such a huge pay rise and would give up, putting all their workers out of a job.

Is that what you think? It’s certainly what the employer-group spruikers want you to think. But it’s nonsense. Hidden within it is a mad assumption, that wages are the only cost a business faces.

Unless all those other costs have also risen by 5.1 per cent, the business can pass on to its customers all the extra wage cost with a price rise of much less than 5.1 per cent.

How much less? That’s a question any competent economist could give you a reasonably accurate answer to by looking up the Australian Bureau of Statistics’ most recent (for 2018-19) “input-output” tables and doing a little arithmetic.

The tables divide the economy into 115 industries, showing the value of all the many inputs of raw materials, machinery, labour, rent and other overheads to the process by which the industry produces its output of goods or services.

Any competent economist (which doesn’t include me, I’m just a journo) could do this, but only two economists from the Australia Institute, Matt Saunders and Dr Richard Denniss, have bothered, in a paper forthcoming this week, Wage price spiral or price wage spiral?

The official tables show that the proportion of total business costs accounted for by labour costs (that is, not just wages, but also “on-costs” such as employer super contributions and workers comp insurance) varies greatly between industries, ranging from less than 3 per cent in petroleum refining to almost 71 per cent in aged care.

But this “labour/cost ratio” averages just 25.3 per cent across all 115 industries.

Now, let’s assume all workers in all industries received a 5 per cent pay rise, and all businesses chose to pass all the extra cost through to prices. By how much would prices rise overall? By 1.27 per cent.

That’s going to keep inflation soaring? It’s well below the Reserve’s 2 to 3 per cent target range.

Of course, that’s just what economists call “the first-round effect”. What about when all a firm’s suppliers put their prices up to cover their wage rises? The “second-round effect” takes the overall rise in prices from 1.27 per cent to 1.85 per cent – still below the target.

Do you remember when the ABC quoted some spruiker saying the cost of a cup of coffee in a cafe could rise to $7? The authors use the tables to show that passing on a 5 per cent pay rise could increase the retail price of a $4-cup by 9 cents.

(Such people are always telling us a crop failure in South America has doubled or trebled the price of coffee beans. It’s the same trick: they never mention that the cost of beans is the least part of the price of a coffee. The biggest cost is often renting the cafe.)

Now get this. That 1.85 per cent rise in prices probably overstates the effect of a universal 5 per cent wage rise, for three reasons.

First, because it assumes zero improvement in the productivity of labour. It’s not great at present, but it’s not non-existent. Second, it assumes firms don’t respond to higher costs by shifting to cheaper substitutes.

And third, because six of the 10 “industries” with the highest labour cost pass-through are either government departments (which don’t actually charge a price that shows up in the consumer price index) or are heavily subsidised by government. Effect on the budget isn’t the same as effect on inflation.

Note that whereas the Fair Work Commission has the ability simply to order a 5 per cent rise in the many minimum award rates covering the lowest-paid quarter of the workforce, should it choose to, the public and private sector employers of the remaining three-quarters of workers are unlikely to be anything like that generous.

That’s a fourth reason the effect of wage rises is likely to be (a lot) less than the authors’ simple calculation of a 1.85 per cent rise in retail prices.

But don’t get the idea wages are the only reason consumer prices rise. Wage rises would explain little of the 5.1 per cent rise in consumer prices over the year to March.

The great bulk of the rise is explained by businesses passing on to retail customers the higher prices of imported goods and services caused the pandemic’s various supply disruptions and the Ukraine war’s effect on energy and food prices.

But some part of that 5.1 per cent rise in prices is explained by businesses deciding now would be a good time to raise their prices and fatten their profit margins. This may not be a big factor so far, but I won’t be surprised if it’s a much bigger one this quarter and in future.

For months the media have been telling us how much a problem inflation has become, with a lot worse to come. Top business leaders and industry lobbyists have used naive reporters to, first, send their competitors a message that “we’re planning big prices rises so why don’t you do the same” and, second, soften up their customers. “Prices are rising everywhere – don’t pick on me.”

It’s quite possible we’ll have trouble getting inflation back into the target range. If so, it won’t be caused by big pay rises – but it’s a safe bet people will be using a compliant media to blame it on greedy workers.

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Cutting real wages will help inflation, but weaken the economy

At last, as the election campaign reaches the final stretch, we’ve found something worth debating. Anthony Albanese has found his spine and supported a big rise in award wages, while Scott Morrison says a decent rise for the masses is a terrible idea that would damage the economy.

First the politics, then the economics. My guess is history will judge this to be the misstep that did most to cost Morrison the election. Successful Liberal leaders – John Howard, for instance – know never to be caught within cooee of a sign saying “wages should be lowered”. It’s not the way to woo outer-suburbs battlers to the Liberal cause.

That Morrison should defy this precedent in a campaign where the cost of living has become by far the biggest issue is all the more surprising.

Between them, the two contenders have revived and highlighted the oldest stereotype in Australia’s two-party politics: the Labor Party is - surprise, surprise – the party of ordinary workers, and will always champion their interests, whereas the Liberals are the party of business, and will always champion the interests of business.

It’s because the Libs are seen as the bosses’ party that they’re instinctively regarded as better at managing the budget and the economy – a mindset Morrison is desperately seeking to exploit in “these uncertain times”.

But the other side of the penny is that Labor, the party of the workers, is the party that cares, and will spend more on providing government services. Which party’s best at industrial relations and wages? One guess.

But how do the minimum wage arrangements work? And what are the broader economic implications of a rise high enough to cover the 5.1 per cent rise in consumer prices over the year to March - or not high enough, so that wages fall in “real terms”?

The Fair Work Commission conducts an annual wage review to determine the increase in the national minimum wage on July 1. Last year’s increase of 2.5 per cent applied to the 2 per cent of employees on the national minimum rate, but also the 23 per cent of employees whose wage is set by one of the various minimum rates for workers in different job classifications set out in each of the more than 100 industrial awards established by the commission.

The national minimum wage rate is about $20 an hour, or about $40,000 a year for a full-time worker. About 2.7 million workers have their wage set in this way.

A 5 per cent increase in the national minimum wage would be worth about $1 an hour or about $2000 a year. Note, however, that many of those in more skilled award classifications would be earning much more than that.

The rises the industrial parties ask for in hearings before the commission are always “ambit claims”. The Australian Council of Trade Unions wants a rise of 5.5 per cent.

On the employer side, the Australian Industry Group says the most its member businesses could possibly afford is 2.5 per cent. The Australian Chamber of Commerce and Industry says the most it could run to is 3 per cent.

Morrison has implied it would be quite improper for a federal Labor government to seek to influence the decision of the independent commission. But the fact is federal and state governments routinely make submissions to provide information about the state of the economy and indicate how generous or tight-fisted they think the commission should be – though they rarely suggest a specific figure.

The commission will give due consideration to a government’s submission but, rest assured, it will do as it sees fit, usually awarding an increase somewhere between the employers’ lowball and the unions’ highball.

My guess is this year’s decision will be a lot higher than last year’s 2.5 per cent, but not nearly as high as 5.5 per cent.

That’s particularly because the commission can be expected to allow for the 0.5 percentage-point increase in employers’ compulsory contributions to their workers’ superannuation accounts this July. The unions would love to have their cake and eat it, but I doubt they’ll be allowed to.

Albanese says, “the idea that people who are doing it really tough at the moment should have a further cut in their cost of living is, in my view, simply untenable”.

Morrison claims a minimum-wage increase sufficient to stop wages falling behind the rise in consumer prices would be “reckless and dangerous”.

The Ai Group warns that “an excessive minimum wage increase would fuel inflation and lead to higher interest rates . . . than would otherwise be the case”. It would be detrimental to economic growth and job creation.

The chamber of commerce says “any increase of 5 per cent or more would inflict further pain on small business, and the millions of jobs they sustain and create. Small business cannot afford it”.

So, what do I think? I think it’s easy to exaggerate the economic cost of giving our lowest-paid workers a decent pay rise. Small business always cries poor and warns jobs will be lost. But there’s little empirical evidence that higher wages lead to job losses.

It’s true that giving a quarter of our workers little or no compensation for the jump in prices caused by pandemic supply disruptions and the Ukraine war would be the quickest and easiest way to get inflation back down to the Reserve Bank’s 2 to 3 per cent target range.

But it would also be hugely unfair to load that burden onto our lowest paid workers, while business profits escaped untouched. The Reserve will just have to be more patient if it doesn’t want to crunch the economy with big rate rises.

And here’s the bit the business lobby groups seem too short-sighted to see. The more we cut the real incomes of our businesses’ customers, the less businesses will be able to sell to them, and the more the economy will be in anything but the “strong” condition Morrison keeps claiming it’s in.

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Inflation: bad for your budget, good for the government's

A big part of the Morrison government’s pitch about being better at economic management than Labor is its claim to have ensured all the massive increase in unfunded government spending during the years of pandemic lockdowns was “targeted and temporary”. Well, not really.

In a paper written by Matt Saunders and Dr Richard Denniss, of the Australia Institute, they study the forecasts and projections out to 2025-26 in the latest budget, which those with long memories will remember was presented at the start of this seemingly endless election campaign.

The authors find that, relative to what was projected in the last budget before the pandemic, annual government spending is now projected to grow at a much higher rate. It’s true annual spending has fallen back from its peak in 2020-21, but not by nearly as much as it should have if all the extra spending had been “targeted and temporary”.

So, what’s happened? I think I know. All the spending programs specifically labelled as part of the effort to hold the economy together during the lockdowns – JobKeeper, the JobSeeker supplement and all the rest – have indeed been wound up as promised.

But last year’s budget and this year’s both contained new spending initiatives that were separate to the explicitly pandemic-related measures. These, like most spending measures, were ongoing. Their annual cost tends to rise over time, in line with inflation and population growth.

If you remember, last year’s budget included much additional spending on aged care in response to the shocking findings of the royal commission, extra spending on the National Disability Insurance Scheme and a big increase in childcare subsidies.

Another thing worth remembering about last year’s budget: whatever the obvious political motivation for that additional spending, the econocrats co-opted it for their Plan B: if after almost a decade trying you can’t get wages to return to their normal healthy growth, why not try getting unemployment down so low that employers have to bid up wages to get or retain the labour they need?

With under acknowledged help from the temporary closure of our borders to all imported labour, Plan B has worked so well it’s now adding to the risk of ongoing inflation arising from all the once-off imported inflation.

But perhaps the most startling thing revealed by the authors’ examination of the budget papers is the way, relative to the pre-pandemic figures, nominal gross domestic product is now projected to grow at quite a faster rate than real GDP.

Why would nominal grow faster than real? Clearly, because of a higher rate of inflation. Remember, however, here we’re talking about inflation measured not as usual by the consumer price index, but as measured by the “GDP deflator”.

Why would the two inflation measures give significantly different results? Because our “terms of trade” had changed. If the prices we receive for our exports are changing at a different rate from the prices we’re paying for our imports.

So the GDP deflator includes changes in export prices, and subtracts changes in the prices of imports, whereas the CPI ignores export prices, but does include changes in the retail prices of imported consumer goods and services.

We’ve been making so much fuss about the bad news of rising import prices, such as petrol and diesel, we’ve forgotten that, as a big exporter of energy and food, we’re a net beneficiary of the Ukraine war’s effect on world commodity prices.

With much additional help from high iron ore prices, our terms of trade improved by more than 12 per cent in the March quarter, to a record high. A record high, and no one noticed.

But here’s the trick: your personal budget benefits only indirectly, if all at, from our booming exports. But it will bear the full effect of higher import prices, which do most to explain why the cost of living is up 5 per cent in a year and headed higher.

The Reserve Bank is confident this year’s round of wage rises will be a fair bit higher than last year’s, but it is adding to home-buyers’ cost of living by putting up interest rates, to help ensure wages rise by a lot less than prices in the period ahead.

So, recent developments not good news for your budget, but great news for the government’s budget. Its revenue tends to grow in line with the growth in nominal GDP. And higher inflation means higher taxes.

Mining companies paying more company tax, consumers paying more goods and services tax and, even despite the continuing fall in real wages, higher income tax collections as whatever wage rise workers do get pushes them into higher tax brackets or otherwise raises their average tax rate. Good news for some.

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Our falling real wages will help control inflation

The media always portray an increase in interest rates as terrible news – and it’s hardly surprising that’s how Anthony Albanese sees it – but Scott Morrison is right in saying rising interest rates are a sure sign of a strong economy.

Rates fall or stay low when the economy is weak, but rise when the economy’s strong growth threatens to give us a problem with high and rising inflation – which is where we are now.

One of the main things we want from a strong economy is lots of jobs, which is just what we’ve been getting. So many jobs have been created over the past two years – almost all of them full-time – that the rate of unemployment has fallen to a very low 4 per cent, and the proportion of working-age people with jobs is higher than it’s ever been.

What could be wrong with that? Well, just that the wages people have been earning from all those jobs haven’t been keeping up with the cost of living. Last week’s news that consumer prices rose by a massive 5.1 per cent over the year to March has made that much worse.

If you want to blame Morrison for that, well, he’s actually right in saying most of its causes – supply disruptions arising from the pandemic; high petrol prices caused by Russia’s war on Ukraine – have nothing to do with our government.

But wages have been struggling to keep up with prices for all the time this government’s been in office. There are things it could have been doing to encourage higher wages, but it’s failed to do them. That’s the legitimate criticism of Morrison’s economic management.

Getting back to interest rates, the truth is that a rise in rates cuts both ways. It’s bad news for people with home loans, but good news for older people living on their savings and for young people saving for a deposit on a home.

Did I mention that nothing’s ever black or white in the economy? Almost everything that happens has advantages for some people and disadvantages for others.

But leaving aside whether individuals gain or lose from higher interest rates, where does the jump in prices leave the economy? How much of a worry has inflation become? Will rates have to rise so high they threaten the recovery? Could we even end up back in recession?

This time last week some business economists were sounding pretty panicky. “The inflation genie is well and truly out of the bottle”, some assured us. Others claimed the economy was “overheating” and, since the Reserve Bank had left it so late to start raising rates, they’d have to rise a long way to get inflation back under control.

But when Reserve governor Dr Philip Lowe announced on Tuesday that the official interest rate – aka the “overnight cash rate” – had been increased by 0.25 percentage points to 0.35 per cent, warned that further rises in rates will be needed “over the period ahead”, and explained how he saw the problem and how it could be fixed, many economists seem to have calmed down.

Implicitly, Lowe refuted the claim that the economy was overheating. Even at 5.1 per cent, our inflation rate was lower than the other rich countries’, and our wage growth so far had been much lower.

So the rise in inflation “largely reflects global factors” – that is, not of our making – but “domestic capacity constraints are increasingly playing a role and inflation pressures have broadened, with firms more prepared to pass through cost increases to consumer prices”.

That is, we don’t have as big a problem as that 5 per cent figure could make you think, but the economy’s growing so strongly we could get a problem if we kept interest rates so low.

Many retailers and other firms have gone for years trying to hold down their costs, including by finding ways to save on labour costs, and avoid passing those costs on to customers, but the rise in their pandemic and Ukraine-related costs – plus the media’s incessant talk of rising prices – has emboldened them to start increasing their own prices.

Now, as Lowe explains, even if petrol and pandemic-related costs don’t fall back down, they won’t keep rising. So in time the inflation rate will fall back of its own accord, provided it doesn’t lead to our firms putting their prices up too high and giving their workers pay rises big enough to fully cover their higher living costs.

If that does happen, the once-only rise in prices coming from abroad gets into the wage-price spiral and the inflation rate stays high.

This is why Lowe has started raising the official interest rate and may keep raising it by 0.25 percentage points every month or so until, by the end of next year, it’s up to maybe 2.5 per cent (which, not by chance, is the mid-point of the Reserve’s 2 to 3 per cent inflation target).

Note that, if 2.5 per cent is roughly equal to the “neutral” interest rate - that is, the rate that’s neither expansionary nor restrictive – this would only involve withdrawing the “extraordinary monetary support” put in place to help us through the pandemic. It would take the Reserve’s foot off the accelerator, not jam on the brakes.

According to Lowe’s estimations, the resulting reduction in mortgagees’ disposable income, plus the likelihood that most workers’ wage rises wouldn’t be sufficient to cover the 5 per cent rise in their living costs, thus reducing their wages in real terms, would limit firms’ ability to raise their prices and so help to get the inflation rate back to the top of the 2 to 3 per cent target range by 2024.

The inflation problem fixed, without crashing the economy. Done at the expense of people with home loans and ordinary workers? Yep. No one said using interest rates to control the economy was particularly fair.

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