"Taxation without legislation" is how economist Milton Friedman described inflation. Friedman saw inflation - when prices increase across the economy - as a tax by stealth, because it reduces the purchasing power of people's income while eroding the value of the government's debt. With yesterday's ABS data showing that inflation is on the rise in Australia, the concern today is even worse: will inflation derail the post-COVID recovery?
Inflation occurs when too much money chases too few goods, causing prices to rise. Right now, Australians are trying to spend more on goods and services than businesses can supply, so it's no surprise we are seeing prices rise faster than usual.
Demand has increased significantly as households spend the money they saved during the pandemic. People aren't spending normally, either. The money they used to spend on services (which tend to involve more person-to-person contact) has been redirected towards goods. The result is a double whammy increase in the demand for goods. Ultra-low interest rates and big government spending throws more fuel on the fire.
This increase in demand couldn't have come at a worse time when it comes to supply. Supply chains are struggling to meet even the normal level of demand, let alone the big increase in demand caused by the pandemic. Workers are dropping like flies as COVID spreads through the community. Many workers, particularly in the United States, have ditched their jobs altogether as part of the so-called "Great Resignation".
Geopolitical tensions aren't helping. China's COVID lockdowns, China's trade restrictions and tensions in Europe are wreaking havoc on supply chains as businesses scramble to source their supply from less risky parts of the world. All of this is pushing up costs and prices.
What should we do about this increase in prices? Policymakers face some brutal trade-offs. The normal solution is for the Reserve Bank to raise interest rates. This cools off demand by making it more expensive to borrow money and by making existing debts more expensive to service. As demand falls, prices stop rising and inflation stabilises.
This is straightforward when inflation is being caused by rising demand. But when falling supply is the problem, there can be a nasty trade-off. If supply is low enough, stopping inflation could require the central bank to reduce demand by so much that it causes GDP to contract and unemployment to rise, triggering a recession. Fiscal policy faces the same problem. Cutting government spending (or raising taxes) will tame inflation, but could also hurt the economy.
Given this awkward trade-off between controlling inflation and potentially causing a recession, two other options are being fiercely debated by economists, particularly in the United States.
The first option is to do nothing. The argument here is that the current burst of inflation is temporary, so central banks are better off tolerating a one-off increase in prices rather than risk causing a recession. What matters is whether workers and businesses begin to think prices will rise faster than central bank inflation targets (2 to 3 per cent a year for the RBA). In fact, higher prices can help shift workers from struggling sectors (like hospitality) into areas where they are needed (such as transportation), meaning central banks should look through the one-off price increase.
There's evidence to support this view. People will eventually run down the money they saved during the pandemic, and they will start switching back to buying services once we start living with the virus. There will be fewer sick or caring workers once Omicron passes and, according to the Federal Reserve Bank of New York's global supply chain pressure index, there is some evidence that global supply chain challenges may have peaked.
But "do nothing" could be a gamble. Even if its causes are temporary, inflation could become more permanent if it lingers for long enough. Inflation is fundamentally driven by expectations. If wage bargainers expect inflation to persist, they could seek higher wages to compensate workers for increased prices, potentially triggering more demand and more inflation. It might also be a bold assumption that the size and composition of consumer spending will quickly return to normal. Assuming no new COVID variants emerge or that geopolitical tensions simmer down might also be too optimistic.
The other option being hotly debated is competition policy. The Biden administration has correctly observed that the level of competition between firms in America is not what it used to be. Concentrated markets have been linked to a decline in the labour share, low productivity growth and low investment, as well as high prices, high markups and rising inequality.
Weak competition between firms results in higher prices and thus inflation. But this happens gradually, not suddenly. There is no evidence that competition suddenly worsened in 2020 and 2021, let alone that this is the cause of recent inflation. This isn't to say that competition policy reforms won't help reduce prices - but the reforms would need to be carefully chosen and highly targeted, while acknowledging that their impact on inflation in the short-term would likely be modest.
Cars are an example. The rising price of used cars has been a significant driver of inflation in Australia. An easy competition policy reform to help ease inflation would be to allow people to import used cars into Australia. This would increase the supply of cars and provide a once-off cool-off in prices. Removing all remaining tariffs on imports is another obvious way to ease prices.
Unfortunately, most of the things that hurt competition in Australia can't be fixed quick enough to solve today's inflation problem. Australia's competition problems are primarily the result of regulations that prevent competition by protecting incumbents (think pharmacies, airlines, coastal shipping), regulations that stop new firms from entering markets (think planning and zoning laws) and a competition law framework that allows too many mergers and acquisitions that have tenuous economic benefits. We should fix these problems, but it will be many years before these reforms ease prices. Competition policy should really be focused on the level of prices, not the rate of change year to year.
So, what should policymakers do about inflation? First, policymakers should do everything they can to ease pressures on supply chains. This is the low-hanging fruit. If there are regulations restricting supply (such as tariffs and restrictions on the imports of used cars) then they should be eased. If there are regulations restricting the supply of labour (such as making it easier for forklift workers to be licenced safely) then those should be eased, too.
Beyond this, it is the job of the Reserve Bank to ensure that the level of demand in the economy is appropriate for the level of supply. But the decision on whether to increase interest rates should be data-driven, and not rushed.
The Reserve Bank should resist the urge to make promises about what it will do years into the future. It should wait to see if inflation gets baked into expectations. If it does, it should raise interest rates, while being willing to reduce them again if inflation turns out to be temporary. The RBA should approach its target symmetrically: if it was happy to be below its inflation target for many years, it shouldn't have a different approach to when inflation is above its target by a similar amount.
In uncertain times, flexibility is critical. And times don't get much more uncertain than this. .
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