Inflation: The Great Enemy
Understanding inflation and the Reserve Bank, our valiant defender against the great evil
There's something different about inflation. It holds a special place in our institutional consciousness as The Problem. It is a cipher for things going badly. It is, in short, our collective economic bogeyman.
Sure, we may dislike things like unemployment, we might prefer not to have gross inequality and if given the choice we probably would opt to have less children going to bed hungry. We've even all agreed, finally, that climate change should be avoided so long as it costs no-one anything to achieve.
But what do we really care about? We are united in agreement that society cannot bear any inflation beyond 2-3%. That’s our line in the sand.
It's so important that we have created a massive institution with the primary mandate of inflation control, handing them unlimited funding and the power to shape the economy itself in the pursuit of that goal, without needing to bother with silly democratic traditions like public accountability or transparency.
What is this central planning authority and why haven't you heard of it before? Well we've been a little crafty haven't we. We didn't call it anything as vulgar as the Australian Central Planning Authority, after all we are free marketeers and don't believe in heavy market interventionism. So instead we gave it a boring, safe name. It's the Reserve Bank. It's not directing the economy, it's just helping 'manage' it... through massive financial intervention in the economy.
This gentle giant is packed full of all the kinds of independent, conflict-free intellectuals that you'd expect for such an important role. We have investment bankers, industry representatives, friends of politicians and at least 1/9th of them are guaranteed to have at least some professional understanding of economics.
As the bank like to say, this arrangement creates a diversity of voices within the board, and it's hard to argue with this. We have managed to create a very diverse sample of the top of the Australian business class.
If pressed and unable to dissemble out of an answer altogether, politicians would probably say unemployment, inequality and poverty are just as important as inflation. I do not however recall us having an institution with uncapped funding to fix poverty and provide meals to kids. We don't have a universal employment guarantee. Far from trying to reduce inequality, in recent decades we've been very effective at increasing inequality through successive, careful adjustments to the tax system.
No, all of these so called priorities are either merely for show, or cast off once the inflationberg appears on the horizon. It's quite clear that when it comes to the economy we care very deeply about inflation and quite a bit less about everything else. The question is why?
First to the basics: what is inflation?
The important thing to understand about inflation is that it represents an average rise in prices (duh), and that wages are one of those prices. Historically wages have been the primary driver of inflation, especially in the pre-globalised world.
Knowing that inflation is about prices, we need to understand more about what actually makes up a price. This is a sufficiently deep question to satisfy its own mind-numbing article, but in summary there are really only a few major components to a price. There are wages, profits, imports, taxes and the cost of money.
Sure there are lots of expenses in a producing a product - transport, electricity, components etc. But when you trace these down, those inputs also have a wage component and so on and so on. Since we do not pay the planet for its basic resources - minerals, water, sun etc (we’re bloody freeloaders), the primary costs to any product are the labour, profits and imports.
Taxes are a complex case but since they don't often change structurally (excluding special cases like a GST change) they rarely are an inflation component.
All of this is really important, because it means we really are going to be looking at three causes for price inflation
1. Workers receiving higher wages per unit of production
2. Companies raising their prices to increase profits
3. Imports getting more expensive due to external factors
All three of these things can and usually do happen simultaneously, and worse, affect each other.
You’ve probably heard something about "supply chain issues", which can really only present itself in the form of a productivity drop, meaning a rise in wages per unit of production. It’s not nearly as big a deal as is often pretended, but what effect it has will be seen in the wages and import inflation.
Inflation today: an import price shock
Let's apply this simplified view of prices to the current situation. According to the ABS, inflation over the last year has been 6.1%. Meanwhile the wage price index has only risen 2.6% in that time. We can immediately see that in the aggregate, wages are not responsible for the current level of inflation and in fact people are in a real sense behind where they were a year ago.
Meanwhile, the import price index has risen 22.1% in a year. Most of this is due to the rise in fuel prices, which is obviously an input to a great deal of production.
Finally, we have corporate profits, which have risen by a whopping 28.5% since the same time last year. While this may sound impressive, almost half of this is from the mining sector alone, having benefited from exchange rate changes and rising commodity prices. Apart from manufacturing, wholesale trade and transport - which has seen an almost doubling in gross profits - most sectors are either flat or down.
What we are left with is not a clear narrative of price gouging to increase profits, with a few exceptions. It is closer to a story of a general import and fuel price shock driving up the price of everything else.
This leaves us with a little bit of a problem. We have our economic central planning authority remember, with the mandate to control inflation. But the inflation is being caused by external factors! What are we going to do about it?
We will… use the only tool we have
The Reserve Bank only has one tool. No matter the problem or its cause, there is only one tool available to fix it. You've heard the saying "When you only have a hammer, every problem looks like a nail". Well the Reserve Bank heard this and took it as guidance.
The Reserve Bank attempt to control inflation through the adjustment of interest rates. How this actually works is quite convoluted and the Reserve Bank has always done a fantastic job at obfuscating what it actually is they are trying to achieve, but it is worth breaking down.
In simple terms, raising interest rates is expected to lower inflation through the following steps:
The Reserve Bank raises the rate used in interactions with banks, who pass on higher borrowing rates to customers
Borrowers find themselves with less money to spend as their interest payments increase
Companies experience lower demand and start laying off people to salvage profits
The unemployment rate rises, capping wage expectations and further reducing demand.
The critical factor is that interest rate rises are meant to hurt people. People who are already suffering from high inflation and low wage growth, will now have the added burden of increased mortgage repayments and unemployment.
Given import prices are externally driven and not directly affected by local interest rates, for this process to successfully halt inflation there will need to be a drop in wages or profits sufficient to offset the imports.
There doesn't seem to be enough slack in profit margins to make a difference, so then it must come down to wages. This partly can be achieved by capping salary increases, but what it really means is businesses putting a halt on hiring.
Enter The Reserve Army of the Unemployed
Unemployment, the age old tool of control. By forcing an increase in unemployment, the Reserve Bank hits three birds with one stone.
First, those individuals will have a terribly unhappy period of their life, will be pilloried as failures due to the stigma we have carefully built into our system of state support, and they will have a lot less money to spend.
Secondly, those business will have less employees and they will work them a little harder, scoring a free productivity boost and improving their wage to production ratio.
Thirdly, there will be more competition for work, so aspiring and existing workers will be less demanding in their pay negotiations, so wage rises will be limited.
After all this has been done, after unemployment has successfully been increased, wages cut, workers worked harder and price inflation brought down again, we can all relax.
Congratulations. You are now Better Off.
It was always about keeping down wages
Central banks are saying they will do “whatever it takes” to bring down inflation. They claim they want to avoid the anchoring of higher inflation expectations, which they say will create a cycle of high inflation.
This is all really just code for managing wage expectations. The central planning authority is worried that if the public believe high inflation is here to stay, they’ll start to demand higher wages.
That’s what inflation concerns have always been about. They would never say this directly, but it underpins all of their decisions. Their primary goal in life is to keep everyones wages down.
In the most recent announcement of a 0.25% interest rate increase, Phillip Lowe said:
A further increase in inflation is expected over the months ahead, before inflation then declines back towards the 2–3 per cent range. The expected moderation in inflation next year reflects the ongoing resolution of global supply-side problems, recent declines in some commodity prices and the impact of rising interest rates. Medium-term inflation expectations remain well anchored, and it is important that this remains the case
The translation here is that the Reserve Bank believe short term inflation is driven by external factors that will self resolve. The last line is key - it’s medium term inflation (code for wage driven inflation) that they are primarily focused on. This is what is driving the need to increase interest rates. They want to deal with a problem that doesn’t even exist yet, that’s how important it is.
Interest rates are merely the convenient lever by which unemployment is adjusted, which in turn will cause enough pain to keep a lid on future wage expectations.
It’s a good lever too, because it is abstract and poorly understood. They have been able to convince people that unemployment and recessions are the unfortunate, unintentional by-products of central bank policy, instead of being the key outcomes.
We are not trying to keep down wages, we are just trying to avoid the anchoring of medium term inflation expectations! Some mighty fine econobabble going on there. It’s barely understandable.
The best part is you'll be told that they are doing this for you! This is all to avoid more pain for you, which they will achieve by adding more pain.
After the latest rise, Phillip Lowe explained their focus on inflation expectations and the link to wages
“It's very difficult for people to accept the fact that wages are not rising with higher inflation".
"That's very difficult and it's causing a lot of people distress.
"But the alternative is wages picking up with inflation, which means inflation is protracted, it means even higher interest rates later on, and even more unemployment later on.
"And that's going to hurt low income people more so. I know this is difficult at the moment, it's going to be difficult for the next year or so until inflation comes down."
This is a nicely circular argument. He’s saying you have to accept interest rate rises in order to avoid… interest rate rises?
We live in a world where the economic establishment is perpetually terrified of wage rises, despite such a thing not being seen for literally decades. In the USA the median worker is behind where they were in the 1970s in real income.
Worker bargaining power has been deliberately destroyed over decades, wage growth successfully suppressed, and yet the central planning authority has kicked into action decisively at the very hint of wage expectations changing in the medium term.
This is what it has always been about. The Reserve Bank is not here for the people, it’s here to protect the interests of the asset owner class.
They were quick to kick into gear to protect asset owners during the financial crisis. It drove interest rates further to near zero to protect asset owners and profits again during Covid.
And now that wages are threatening to rise, it has jumped into action again, ever ready to protect the interests of the capitalist class.