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:
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.
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.