Comment

John Hewson
Inflation unleashed

As the weeks roll by, it’s becoming easier to believe that the inflation task is slipping away from the government and central bank authorities.

Inflation numbers have already exceeded predictions, even after seven consecutive increases in the cash rate. That means the government can’t afford to be too successful in its push for higher wages, in case they contribute to the rising cost of living and expectations of more inflation to come, in a vicious cycle. So it is focusing on initiatives to increase wages in what is hoped will be a non-inflationary way, by tweaking bargaining rules.

The Reserve Bank of Australia also faces a conundrum: having left policy too loose for too long, it now risks sparking a recession if it moves too far too fast, or stoking inflation if it moves too slowly. In both cases, policymakers are overestimating their power over the problem.

There is a fundamental flaw in the approaches of both the government and the Reserve Bank: they are acting as if their actions will enable them to “fine tune” inflation outcomes. The RBA argues that a series of small increases in the cash rate will return inflation to its target band of 2-3 per cent, while the government argues that industrial relations policy adjustments will deliver the promised increase in wages. It is beyond time to consider the reasonable limits of these policies.

The government’s tweaking of IR rules is high risk. The thrust of its push for multi-employer bargaining is via increased union power, to compel wage increases with the threat of industrial action. Experience suggests this can have serious inflationary consequences.

It is easy to forget that economics is not an exact science, but a difficult blend of science and art. Although economics is in part the application of scientific method in terms of mathematics, statistics and econometrics, good economic policy still relies heavily on judgement. While much can be learnt from modelling and evidence about key economic relationships and their causation, the precision of the maths and the model predictions depends at least as much on the assumptions involved, what is included in the model design and, importantly, in the interpretation of the results.

As for the flaws in the RBA’s approach – it was a significant failing to ignore the context of its monetary policy response to the pandemic stimulatory packages. The RBA pursued a bond-buying program (quantitative easing) on top of the large budgetary stimulus to support the economy throughout the various necessary restrictions, including border closures. This allowed the Morrison government to boast of the hundreds of billions of stimulus from his government and the central bank. It’s now a little late for the RBA governor, Philip Lowe, to be calling for fiscal restraint and budget repair as essential to an anti-inflationary strategy.

Another important contextual point is that the RBA should have been more aware of the significance of household and corporate debt structures before underwriting a huge boost in bank lending – particularly given that household debt levels were among the highest in the world – thereby compounding the cost-of-living problems for households as interest rates rebound. These are key examples of where the RBA could have demonstrated more independence.

It is a structural weakness in the conduct of monetary policy that the RBA actually believes it has a successful track record of having got inflation under control in the 1990s. That was more likely a result of the Chinese economy effectively flooding the world with cheap manufactured products, which led to a substantial reduction in the cost base of many industries.

The RBA’s focus on raising interest rates as a response to mounting inflationary pressures today ignores the fact that most of them are not demand driven but due more to supply-side factors and supply chain disruptions. It is most unlikely that factors such as container and pallet shortages, and semi-conductor and chip shortages, will be addressed by increased interest rates.

Moreover, it is crucial to recognise that interest rates are a blunt instrument – it is just as easy to push interest rates down and keep them too low for too long, as it is to raise them too fast, too high, and then hold them there for too long. Monetary policy can be unreliable, with its effectiveness depending on the context in which it is deployed.

The recent experience of Trussonomics in Britain emphasises the importance of co-ordinating monetary and budgetary policy. Many central banks globally embraced quantitative easing as a mechanism to lower long-term bond rates, thereby reducing the cost of capital for major infrastructure projects, and to bring these and other spending forward. The use of this unconventional tool spurred debate over the possible merits of modern monetary theory, an economic magic pudding. This theory can be taken to suggest that Treasury debt issued to finance such projects could be bought by the central bank, making it simply a transfer within the state bureaucracy that could at some point be written off by agreement between the two. Magic indeed – and highly inflationary.

It is also hard for the RBA to control the reaction of the major economic players to its forward guidance, or so-called “jawboning”, on which it relies heavily to influence expectations. The governor has admitted recently that the RBA overdid this in creating the expectation that interest rates wouldn’t rise until 2024. In any business this would be considered false and misleading conduct, subject to significant penalty. There is a very real question, which perhaps the Reserve Bank review will address, of whether that was a board or a management decision. Good governance demands an answer and some accountability. Recently, the governor has been more cautious in his statements, although the RBA has several times revised its statements as to the likely path of inflation, its peak and duration, which are somewhat different to the budget predictions. The RBA is, of course, conscious of the likely impact on inflation if wages increase too fast, and the effect that can have on inflationary expectations. It is a particularly sensitive area for the government.

Another constraint on monetary policy, in a world where the central banks of most major developed economies are also reversing their interest rate strategies and, in some cases, raising rates quite quickly, is the impact on our exchange rate. If our interest rate increases are too far behind the US and other major countries, this can lead to a devaluation of our dollar, which, in turn, will be inflationary. The RBA has, surprisingly, said little about this. In recent months the United States Federal Reserve has pushed interest rates up dramatically, more than the RBA has done. This has strengthened the US dollar globally as well as against our dollar, although we haven’t devalued by as much on a trade-weighted basis. A weaker currency can be helpful in times of trouble – Australia weathered the Asian crisis by accepting a much weaker dollar – but not so much when the trouble is inflation.

All up, it seems inflation will be with us for some time to come. It will probably peak higher and later than has yet been admitted by either the government or the RBA. And there is little to suggest that its course will be controlled.

Although the government and authorities aim to avoid a recession, it is possible that not even a recession, with a significant increase in unemployment, would be sufficient to reduce inflation to a manageable range.

However, if a recession is around the corner, another round of interest rate cuts couldn’t be ruled out, to start the whole process again.

This article was first published in the print edition of The Saturday Paper on November 12, 2022 as "Inf lation unleashed".

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