Inflation: Is the cure worse than the disease?
by Frank StilwellProfessor of Political Economy, University of Sydney
Inflation in Australia has recently risen a little – to a rate of around 3.6 per cent per annum. The Reserve Bank of Australia (RBA) has responded by increasing the official rate of interest because it deems that an annual rate of inflation above 3 per cent to be unacceptable. Other banks have followed suit, raising interest rates on mortgages by even more in some cases.
Is this monetary policy response a bigger problem than the inflation itself? Will it get to the roots of the inflationary process? What alternative policies could be implemented? These are issues needing investigation that challenges the 'conventional wisdom'.
Rising prices have adverse effects, of course, particularly for people on tight budgets. Wage earners and pensioners who cannot readily increase their incomes to match the inflated prices of goods and services face particular difficulties. However, the rising interest rates create yet more severe problems, particularly for aspiring homeowners and for small business people who rely on debt finance.
Increased interest rates certainly do cause social pain. Orthodox economists – though they seldom publicly admit it – privately concede that that is precisely the point. Higher interest rates dampen inflationary pressures by adversely impacting on consumption and investment. In other words, they depress people's spending levels (other than spending on interest payments, of course). In the extreme, higher interest rates generate recession and widespread unemployment, as they did when the 'recession we had to have' was caused in 1989-91 by the high interest rates when Paul Keating was Federal Treasurer. So the problem of inflation is solved at the expense of a bigger problem of unemployment.
Inflationary processes and tight monetary policies always have important distributional effects too. Broadly speaking, inflation hits hardest at those with fixed incomes while it expands opportunities for capital gains by those with substantial holdings of assets like land. High interest rates benefit those with capital to lend – typically the wealthy – and hurt those who are in debt. So it is important to assess what is the appropriate response in these troublesome economic circumstances. That requires, first and foremost, seeing the inflation in historical perspective.
Inflation still relatively low
Current inflation in Australia is quite modest by historical standards. Australian Bureau of Statistics (ABS) figures show that the annual average rate of increase in the Consumer Price Index (CPI) was about 12% between 1973 and 1983. In the next ten years annual CPI rises averaged around 7%. Since then they have been mainly in the 2 to 4% range, dipping to zero in 1997 and peaking around 5% in 1995 and 6% in 2000.
This historical perspective shows how small are the recent changes in the rate of inflation. An annual rate of around 3.6% is far from exceptional. The monetary authorities should certainly be watchful of any trend that might return us to the 'bad old days' of inflation in the 1970s and 1980s, but there should be no panic. We are still in a low inflation era.
Rising prices of what?
It is also important to look at which particular commodity groups have had the rising prices. The ABS evidence shows that the three sectors where prices have risen most significantly over the last year are transportation, housing and financial services. These stand out as the big three during 2007 – rising by 5.6%, 4.8% and 4.9% respectively. The prices of some other items hardly rose at all – food by an average of 1.2% and clothing and footwear by an average of 1.6%, for example. The average prices of household contents and services actually dipped by 1% over the year.
If the CPI figures are adjusted by removing the three most inflationary sectors, the overall situation looks remarkably stable. Excluding transportation costs, for example, CPI increased by 2.6% during the year. If housing costs are excluded, CPI increased by only 2.5%. If you take both housing and financial services out of the CPI, the ABS data shows that inflation over the last year was a mere 2.2%, which is well within the Reserve Bank's limit of an acceptable rate of inflation.
What is driving inflation?
Judging from the popular media, one might think some sort of 'wages explosion' is driving inflation. There have been predictable calls for further wage restraint. Kevin Rudd's decision to freeze parliamentary salaries, although showing commendable restraint 'at the top' and a good sense of populist politics, tends to fuel this perception of what drives inflation. More substantially, the assertions by conservative economic commentators that now is not the right time to be rolling back the WorkChoices industrial relations arrangements put the blame on labour. This is predictable but unhelpful.
Some people have certainly been enjoying dramatic increases in their incomes, most obviously the chief executive officers of large corporations. That is the source of considerable social inequity but to represent it as the driver of inflation is probably misleading. Looking more generally at profits is significant though. The percentage share of profits in the national income last year was the highest it has been since 1960. So it makes more sense to regard inflation as profit-driven rather than wage-driven. What is remarkable about the current situation is that inflation is not higher than it actually is. This is because of what is happening in the three principal sectors driving inflation – transportation, housing and financial services. Take transportation for example. Oil prices are now around $100 a barrel, up from around the $30-35 mark that prevailed a few years ago. Those fuel prices flow through into the costs of transportation and add to the point-of-sale prices for a wide array of goods. In these circumstances the overall inflation rate is surprisingly modest.
Housing prices are the second sectoral driver of inflation. Underlying these are the conditions in the land market. Over the last decade, land prices in the major metropolitan areas have typically doubled, much more in some cases. This land price inflation causes higher costs of housing and, by adding to rents paid by commercial enterprises, increases the costs of production for an array of goods and services. The land price inflation itself is driven by a constellation of factors, including immigration, metropolitan concentration and the various tax advantages that favour land owners. The failure to apply a uniform land tax, of the sort that followers of Henry George have consistently advocated, means that we do not have the necessary policy in place to restrain the long-run inflationary tendencies arising from land markets.
Third, the costs of financial services are inflationary. Banks have been making massive profits by raising their charges. Commissions extracted by financial services providers have been exorbitant. This is reflected in the extraordinary payments made to CEOs such as Macquarie Bank's Allan Moss who got over $32 million income last year. The deregulated financial institutions have not been serving the nation well.
Current Policy Responses
None of these factors driving inflation are directly addressed by the dominant policy response, emphasising tight monetary policy. Indeed, it is often said that using monetary policy as the principal tool of economic management is like using a heavy, blunt instrument. If you bludgeon the economy hard and often enough it certainly has a depressing effect. However, it is insensitive to the interests of different sections of the economy and society.
Tight monetary policy impacts adversely on the economy as a whole, ignoring what is sometimes described as the 'two speed' economy. Some economic sectors and regions are buoyant while others are not, but all are impacted by the higher interest rates, causing yet more economic adversity in the latter sectors and regions, including rural areas. The fundamental problem is that economic management has come down to a single objective and a single policy instrument – the objective of keeping inflation below 3 per cent per annum and the policy of adjusting the interest rate to achieve that goal. This is a remarkably crude approach to economic policy. Economists trained in the Keynesian tradition, for example, have traditionally argued that the policy objectives should also include full employment and that the policy instruments should also include fiscal policy, trade policy, incomes policies and industry policies.
Fiscal policy seems to be largely off the agenda of counter-cyclical economic management because of the neoliberal policy fetish for surplus budgets. The only question, apparently, is how big the surplus should be. Notably though, economic commentators are now recognising that the expansionary fiscal policy implied by Rudd's election promise to cut income taxes is at odds with the contractionary monetary policy now being pursued. Driving with one foot on the accelerator and the other on the brake produces a very uncertain velocity.
What should be done?
A more selective microeconomic policy response is required. This should emphasise: (a) controlling the sectors of the economy that are driving inflation, and (b) protecting the most vulnerable sections of the community.
Controlling the drivers of inflation requires policy measures targeted at transportation, financial services and land. None of this is easy. Controlling the price of petrol - the key inflationary factor in transportation – is particularly difficult since the price hikes are international in origin, deriving from the long-term depletion of the raw material, the effects of war in the Middle East, and the exercise of monopoly power by the oil-exporting nations and the transnational oil companies. The Rudd government has moved to monitor petrol prices at the bowser, which is commendable, but a more important policy would be to invest in alternative energy sources and technologies that reduce long-term dependence on oil.
The second area to target is financial services. As noted earlier, the prices of these services have been a major driver of inflation. The case for selective re-regulation of financial institutions warrants serious consideration in these circumstances.
The third focal point should be land. Inflationary processes are bound to continue, albeit overlaid by a boom-slump cycle, while land speculation remains prevalent. A policy of uniform national land taxation would remove the incentive for speculation and the cyclical inflationary tendencies that result. That would have the opposite effect to the existing tax rorts that have fuelled the inflationary processes in land and housing markets. It would take considerable courage by the government to withdraw those tax breaks and to embrace the land, housing, urban and regional policies that are necessary to reduce the inflationary pressures in the longer term.
It will also be interesting to see whether the Rudd government makes any serious efforts to develop more interventionist incomes policies, trade policies and industry policies. It is in those policy areas that a more sophisticated alternative economic strategy could be sought. The need for regulation of monopoly profiteering - in relation to grocery as well as petrol prices - is one element that the Rudd government has acknowledged. Promoting high productivity and ensuring that its fruits are well distributed is even more fundamentally important to maintaining a low-inflationary economic environment in the long term.
Finally, there is the need to safeguard low income earners from the effects of inflation in the meanwhile. The Australian Fair Pay Commission, set up by the Howard government, provides one such vehicle because of its authority to set the minimum wage. Its last decision was to set this minimum at a level insufficient to keep up with inflation, so low paid workers wound up worse off then before in real terms. This should not be allowed to happen again.
Conclusion
Inflation is a significant, but not dominant, problem. Tight monetary policy creates a yet bigger problem, especially in the current uncertain economic conditions where the prospect of an economic recession is of increasing concern.
A more sophisticated policy response is required. That response should deal with the particular circumstances relating to land, financial services and transport as well as macroeconomic management. It must safeguard the interests of low and middle income earners and put the principal policy focus on regulating the uses of capital that underpin the inflationary problem. We should not be foregoing the possibility of progressive economic and social reform just because the inflation rate has slipped a little outside the RBA's target range.
Source: Australian Options, Issue 52, Autumn 2008, pp. 3-6.