Articles – The Centre for Independent Studies

We really don't want to have to deal with runaway inflation

Simon Cowan

20 November 2021 | Canberra Times

Last week it was revealed that US Consumer Price Index rose by more than 6% in the 12 months to October. In fact, it was reported that prices rose by almost 1% just in October. Core inflation, which excludes more volatile items, was above 4.5%.

Commentators in the US are starting to sound the alarm, fearing a return to the days of double digit inflation and interest rates. Data analysis website, fivethirtyeight, reported that a majority of Americans (including 92% of Republicans and 78% of independents) are dissatisfied with the price of consumer goods like food, clothing and household items.

Inflation is on the rise in Australia, too. CPI figures from June showed a 3.8% rise — though it fell to 3% in September — and underlying inflation remains 2.1%. The Reserve Bank’s target is to achieve an average of 2% to 3% over time.

The RBA is still largely unconcerned about this growth in inflation; remaining committed to keeping rates low for the foreseeable future, citing low wage growth pressures as one of the key differences between Australia and the United States. There are some indications that the surge in inflation in the US is actually caused by short-term factors (like disruptions to supply chains), and the inflation rise will be temporary.

It’s also true that the US government and the US Federal Reserve has been running extraordinarily accommodative fiscal and monetary policy for years now. In part, this is because the economic effects of these policies have been of secondary importance to US politicians.

For example, Biden’s various packages in the US have undoubtedly spiked inflation — yet the pressure is on to pass even more elaborate and extensive spending plans aimed at mollifying the progressive party base.

Thankfully, Australian policymakers have been relatively restrained (for politicians) when it comes to using the pandemic as an excuse to fulfil supporters wish-lists.

The Reserve Bank too — as has often been the case in recent years — has been cautious about over-reacting to short term fluctuations. So much so, in fact, that some might suggest a more appropriate adjective for the bank is timid.

Indeed, for years the bigger problem was arguably not too much inflation, but too little. Despite near-constant predictions from global inflation hawks that this latest massive, unnecessary, stimulus package would be the one to restart runaway inflation, it remained stubbornly low across the western world.

Another relevant point is that some of the big price spikes in the United States — for example, energy prices — have been less evident in Australia. In this case, it is not so much because energy prices have remained low in Australia, but more that prices were so high to begin with that they could hardly spike much more.

A cynic might also note that house prices, which are rising at nearly 6% per quarter in Australia, are excluded from CPI calculations and therefore not part of inflation considerations. However, they still have a significant impact on household expenses.

Indeed, this is not the only connection between house prices and inflation. Perhaps the greatest concern regarding rising inflation is the corresponding increase in interest rates, and the unaffordability of large mortgages in a non-zero interest rate world.

It bears repeating that this fear, while widespread, can be overstated. People assume that interest rate rises will effectively occur in a vacuum — their income will remain unchanged while interest rates rapidly rise by three or four percent or more.

Not only has nothing like this happened in the last 30 years, but in practice, interest rate rises will almost certainly be accompanied by strong economic and wages growth. In fact, the RBA reinforced this view by expressing hesitation to raise interest rates at all until wages increases were well above 3%.

In truth, some inflation would probably be a good thing, given the enormous debt held by Australian households, and governments around the world. Inflating away debt is far easier than imposing discipline on spending.

Very low inflation has also likely been a handbrake on potential economic growth.

That said, it would not be a good idea to underestimate the negative impacts of inflation, especially high, volatile inflation. Inflation was a word that once sent shivers down the spine of policymakers everywhere.

There are significant downsides beyond potential mortgage affordability issues. Historically, inflation has been a regressive force, transferring income and wealth from the poor to the rich.

Inflation eats away at the value of savings and investment, particularly because of its impact on tax. Taxation is calculated on nominal returns and income: inflation raises nominal returns without increasing real returns — meaning you pay more tax on the same real return.

For wage income, the story is even worse because the tax system is steeply progressive. Inflation increases the average rate of tax paid in real terms and pushes people up tax brackets, meaning they pay even more tax. This effect is actually quite regressive, hitting lower income earners harder than high income earners.

For those on fixed incomes, inflation is a disaster.

There is little wonder inflation was a huge political issue. Those who were credited — rightly or wrongly — with slaying the inflation dragon loom large in political history. Luminaries such as former treasurers Keating and Costello, former US Federal Reserve chairman Paul Volcker and president Ronald Reagan, not to mention former UK prime minister Margaret Thatcher.

Many others failed.

It took decades of extremely difficult reform to get inflation back under control. It would not be a good idea to forget the pain of history.

We’d best hope the inflation doves are right. It is hard to see how the current generation of politicians have even a fraction of the backbone necessary to face down runaway inflation.

Simon Cowan is Research Director at the Centre for Independent Studies.

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