Dinty Mather, Economic Policy

Key issue

After decades of low inflation (see the article ‘Australia's cost of living’, in this Briefing book) and low interest rates, a number of OECD (Organisation for Economic Co-operation and Development) countries – perhaps most notably the US and European countries – are grappling with sharply rising inflation. Australia has also recorded rises, albeit less dramatic.

Rising inflation is typically understood as increasing consumer prices. However, there are a range of prices in the macroeconomy like consumer prices, producer prices, wages, and interest rates. The relationships between these prices impact on wellbeing.

An event can lead to a change in one macro-economic price, (for example, consumer prices),- and then leave the broader economy out of balance, (for example lowering real incomes).

Parliament and government have several policy measures to rebalance macro-economic prices. But these come with risks; for example, causing inflationary spirals. Persistent imbalances may occur when one of the macro-economic prices, like wages rates, cannot rebalance under normal economic policy.

Abrupt and disruptive changes can destabilise what economists call ‘macro-economic systems’ and what we conventionally understand as the economy. As the International Monetary Fund Managing Director, Kristalina Georgieva recently stated:

Russia's invasion of Ukraine has "compounded" the effects of the Covid-19 pandemic, weighing on the economic recovery and fanning inflation as the cost of food and fuel jumps.

Rising interest rates are adding to pressure on countries, companies and households with big piles of debt. Market turbulence and ongoing supply chain constraints also pose a risk.

And then there's climate change.

Governments can influence domestic macro-economic prices to some extent, mainly through targeted fiscal and monetary policy, and thus how the economy adapts and rebalances.

This article explains what inflation is and how it interacts with other prices in the economy. It then examines the tools available to Parliament and government to manage inflation – but with the caution that poorly designed government interventions can result in a prolonged and disruptive inflationary spiral. Also, the failure of one macro-economic price to rebalance might indicate structural problems requiring a regulatory policy response.

Macro-economic prices and stability

Very broadly, prices can be very good coordination mechanisms that balance the opposing forces of demand and supply and bring about stable market conditions. Macro-economics deals with the aggregate of all goods and services produced in an economy (usually represented by gross domestic product or ‘GDP’) and consequently talks about aggregate demand and aggregate supply.  ‘Macro-economic’ prices are related to these aggregate settings, in particular by coordinating and supporting major purchase, investment and production decisions. The 3 most common macro-economic prices are:

• commonly understood prices: including aggregated consumer prices (like CPI) and aggregated producer prices
• the price of labour: general wage prices that impact production costs and consumer income
• the price of capital or ‘money’: things like interest rates that affect asset pricing (and the cost of borrowing by firms to expand production or as a cost for consumer credit and an incentive to save).

On a simplistic level, with a stable general price level (a constant inflation rate) aggregate demand is balanced to aggregate supply with no excessive upward pressure on wage rates through the labour market and the aggregate demand for investable funds is balanced with the aggregate supply of savings under stable real interest rates.

Quite often disruptions outside a government’s control (exogenous shocks) impact on macro-economic price stability. The market distortion from these shocks is most noticeable to the public as rising consumer prices (or ‘headline inflation’), higher interest rates, stagnant wages and falling standards of living. The traditional or theoretical way of thinking about rising inflation is that it can start when:

• the aggregate demand for goods and services exceeds the aggregate supply (‘demand pull inflation’), usually due to some stimulus to demand like expansionary monetary and fiscal policies
• the aggregate supply for goods and services declines (‘cost push inflation’) caused by, for example, rising energy prices and/or rising wage costs.

Disruptive inflation occurs when inflationary spirals emerge. As a simple example, if a ‘shock’ results in consumer price increases, wages may rise in response. The increasing wage costs then drive up consumer prices, leading to second-round price rises. This process creates an inflationary spiral, exacerbated when people pre-emptively demand higher wages by expecting higher prices; that is, inflationary expectations drive inflationary spirals.

Rising inflation requires upward adjustments of the other 2 macro-economic prices to maintain a stable macro-economic system:

• nominal interest rates should rise in line with inflation to keep real interest rates (inflation adjusted interest rates) stable
• nominal wages should rise with inflation to keep real wages (inflation adjusted wages) stable.

If nominal interest rate policy adjustments are below the level of inflation, then the real interest rate falls. Falling real interest rates can become problematic because they create incentives for individuals and firms to borrow more, asset prices to rise, and individual to save less. Falling real wages result in lower standards of living and possible social disruption depending on how rapidly and by how much living standard drop. A government’s ability to rebalance only one macro-economic price when general prices rise points to potential regulatory problems.

Policy tools

Government can use 3 broad sets of policy tools to influence prices and economic outcomes: monetary policy, fiscal policy, and regulatory policy. All 3 can be used to stimulate (speed up) or contract (slow down) the economy and are distinguished by their effective time frame and how quickly the measures can be reversed or changed. The selection of policy tools to deal with rising inflation depends largely on:

• what caused inflationary pressure in the first place (the type of shock)
• how long inflationary pressure is expected to last
• whether inflation has exposed, or created, structural problems that need to be addressed.

Monetary policy includes setting the cash rate (which influences interest rates) and other measures, for example, quantitative easing (see Box 1). Monetary policy decisions are made independently by the Reserve Bank of Australia (RBA), can be changed quickly, and be effective in a relatively short time. Monetary policy is most applicable if the shock is expected to have a limited price effect and short duration.

Quantitative easing and quantitative tightening

Quantitative easing is when the RBA purchases a targeted quantity of assets (usually government bonds purchased from private institutions) to lower a range of interest rates. The RBA pays for these purchases by creating ‘central bank reserves’.

In response to the COVID – 19 slowdown, the RBA instituted quantitative easing from November 2020 to February 2022. In the face of rising inflation the RBA, starting in March 2022, entered a phase of what it calls quantitative tightening in the sense that it would not create additional ‘central bank reserves’ to purchase any more government bonds.

Australian fiscal policy settings are normally set out in the Budget and include setting tax rates, government spending and borrowing. For shocks that are expected to have a limited time span, a temporary expansion in government spending and/or a lowering of tax rates (stimulatory fiscal policy) can be financed out of government borrowing, but at the expense of rising government debt. Temporary fiscal policy measures usually last at least a year, take longer to be effective, are more difficult to reverse, and often display lingering consequences.

Regulatory policy, (for example competition policy), can impact all aspects of the economy. However, regulations affecting business profitability and labour markets have important impacts on macro-economic prices. Regulatory policy tends to create long lasting, or structural, effects on the economy and can be difficult to change.

Policy responses to inflation

Recently the world has experienced 2 wide - reaching exogenous shocks in the form of COVID – 19 lockdowns and the Russian invasion of Ukraine. The effects of COVID–19 stimulatory policies on inflation were expected to taper off when lockdowns ended, and stimulatory policies were removed. However, inflationary pressure has continued and short-term estimates have been consistently reviewed upward, largely due to the possibility of a prolonged Russian war in Ukraine.

COVID–19 induced inflation

The COVID-19 ‘lockdown’ measures resulted in an unexpected disruption in the supply chains which coordinate the distribution of goods and services (supply) sought by businesses and consumers (demand). These coordination problems led to supply chain disruptions and lost trading opportunities. Together, these problems created excess (pent up) demand which could not be fulfilled. In addition, governments embarked on stimulatory fiscal and monetary policy to counter the economic and social impacts of COVID–19 lockdowns.

These circumstances led to upward pressure on consumer and producer prices, leading to increasing headline inflation. Because the drivers of inflationary pressure were COVID–19 dependent, once the cause (lockdowns) was removed, then the inflationary pressure was expected to subside. The danger was that inflationary expectations could spark an inflationary spiral.

Australia’s policy response intended to stem rising inflation and calm expectations of inflationary spirals by implementing:

• low cash rates in an attempt to hold interest rates steady (monetary policy)
• a substantial reduction in stimulatory policy by reigning back COVID-19 support packages (fiscal policy)

Together these policies were designed to simultaneously remove the causes of inflation and retard wage cost inflationary spirals. However, just as the economy was recovering, the Russian invasion of Ukraine resulted in a major supply shock needing a revised policy response.

Russian invasion of Ukraine and inflationary expectations

Russia is a major oil, gas, and metal supplier, and both Russia and Ukraine supply significant amounts of wheat and corn. The Russian invasion of Ukraine led to a continuing decline of these commodities into world markets. The supply shortages (supply shocks) have driven up prices in world markets and slowed economic recovery and have affected almost all countries in the world. The impact across countries has been unequal.

These supply shocks have challenged temporary inflationary expectations. The uncertainty as to when the conflict will end, and food and energy supplies normalise, has led to persistently rising headline inflation, renewed inflationary expectations, and possible inflationary spirals.

An important component of rising consumer prices in Australia is increased fuel prices and the increased cost of transporting goods. However, because Australia is a net exporter of agricultural goods and hydrocarbon fuels, the Russian invasion of Ukraine has also had some positive results for Australia. Higher agricultural prices, and mining and energy prices leave farmers and miners potentially better off, but may be offset by rising input costs. It also exerts upward pressure on domestic food prices.

The Russian invasion of Ukraine extended inflationary stress leading to more persistent inflationary pressure globally. Whether or not rising inflation will become entrenched and become stagflation (high inflation and low growth) is still uncertain. What is certain is that consumer prices have continued to rise, and the policy challenge is to manage inflationary expectations while at the same time ensuring that firms remain viable and living standards are maintained.

Although Budget 2022–23 introduced a cost of living support package, fiscal stimulatory spending had already been substantially reduced in response to COVID–19 induced inflation. The RBA was initially reluctant to increase the cash rate because of its influence on inflationary expectations and uncertainty around the Russian-Ukrainian war.

Subsequently, the RBA signalled further regular cash rate increases, most recently increasing the target by 50 basis points in June 2022. This is expected to flow through to higher nominal interest rate rises, including mortgage rates. The pace and quantum of the increases are important in moderating inflationary expectations. The RBA has already started quantitative tightening, although it expects this measure to have a minimal effect in the short-term.

Policy futures

The war in Ukraine will continue to put upward pressure on wages and raise the possibility of an inflationary spiral. This rising inflation can potentially erode real wages and reduce living standards, particularly among the poor and vulnerable. Falling real wages in the face of rising inflation can indicate a transfer from wages to profits. However, real wages can remain constant during rising inflation (nominal wages increase at the same rate of inflation) without causing inflationary spirals because inflationary spirals are caused by inflationary expectations, not constant real wages.

Stagnant nominal wages (where inflation is greater than or equal to wage growth) are not typical of a well-functioning labour market, which adjusts to inflationary pressure through increased nominal wages. Situations where this is not the case indicate possible:

• structural problems in the labour market arising from, for example, weakened collective bargaining (regulatory policy)
• emerging labour market problems, such as those associated with insecure or under-employment.

These structural and emerging problems, which are evident in current Australian pricing, have resulted in an erosion of wages and living standards, but increased profits. Rising inflation is expected to exacerbate this problem.

In addition to labour market problems, welfare transfers and benefits are considered stimulatory, particularly if kept in line with inflation. Slowing inflation with policies to reduce nominal welfare transfers and benefits (particularly when coupled with lower or constant company taxes and a transfer of wages to profits) creates socioeconomic imbalances including increased intergenerational inequity, in addition to price imbalances.

Policy approaches to achieve macro-economic price balance, and by implication social and political stability, are formed within a contextual framework about how the economy works. These frameworks, of which there are many examples, create vested interests and seem only to change in times of crisis. The COVID–19 pandemic, a worsening geopolitical landscape, fracturing international trade and climate change may be the trigger for an innovative re-evaluation of the contextual frameworks within which Australian economic policy is thought about.

Further reading

International Monetary Fund, World Economic Outlook: War Sets Back the Global Recovery, (Washington, DC: IMF, April 2022).

M. Saunders & R. Denis, Wage Price Spiral or Price Wage Spiral? The Role of Profits in Causing Inflation, (Canberra: The Australian Institute, May 2022).

Reserve Bank of Australia, Statement on Monetary Policy, series.

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