Inflated half truths
21 December 2023
A self-indulgent look at my LinkedIn posts over the past year reveals that I have made at least 15 posts on the subject of inflation, or what is being done to bring it under control. The tone of each has shifted over time from polite questioning to angry assertions. This article is an attempt at collecting together my thoughts in one place and providing a clearer and more tempered articulation of what boils down to five half-truths that have been at the core of my frustrations:
1. high inflation is increasing our cost of living;
2. strong demand explains high inflation;
3. there is a Non-Accelerating Inflation Rate of Unemployment;
4. wage increases risk driving inflation higher; and
5. migration is driving up inflation.
1. High inflation is increasing our cost of living
The Consumer Price Index (CPI) measures the overall change in consumer prices based on a representative basket of goods and services over time. It is the most widely used measure of inflation followed by policymakers, financial markets, businesses, and consumers.
When the CPI increases that means that we are paying more for the items in that representative basket than we were previously. In other words, our cost of living, as measured by the CPI, has increased. On this measure, inflation has been on the increase since it dipped momentarily into negative territory in June 2020. And we have all felt it as we have paid more for the price of our favourite cereals, or paid the same for quietly shrunken volumes. While the CPI peaked around this time last year, it continues to lie outside the band of two to three percent that the Reserve Bank of Australia (RBA) is targeting.
Rising cost of living as suggested by the CPI
Increase in the CPI in the previous 12 months, percent
If you search through the CPI basket of goods and services what you will not find is mortgages. Rather than measure the cost of purchasing a home, what the CPI measures is the cost of building a home. The reality is that 37 percent of Australian households have a mortgage. For those households a big determinant of their cost of living is how much mortgage they have to pay.
Thus, as interest rates have progressively cranked up as the RBA attempts to bring inflation under control, the cost of living faced by mortgagees, not to mention other individuals and businesses with loans, has also increased. Alternative indices calculated by the Centre for Economic Policy Research finds that homeowners with a mortgage have experienced a very large cost increase over the past two years of 17.5 percent – much more than renters who have had an average increase of ‘just’ 10.8 percent, and outright owners who have had 11.7 percent. First homebuyers who bought within the past three years faced the biggest living cost increase, of 20.5 percent.
2. Strong demand explains high inflation
As I have attempted to depict in the picture that graces this article, Economics 101 tells us that inflation is the outcome of "too many dollars chasing too few goods.”
Much of the policy focus and media commentary has focused on the dollars that are doing the chasing. Or, more formally, the demand side story. This story will be familiar to many of you. It goes along the lines that the largess of Commonwealth and state governments, designed as a counter to COVID restrictions, plus either the inability or caution of many of us to spend over that period, has resulted in swollen savings and pent up demand as we now enjoy our rediscovered freedoms. However, with not enough goods to go around, prices have necessarily had to increase in order to quell our demands.
The policy lever wielded by the RBA is designed to reduce the number of dollars doing the chasing. That is, by raising interest rates we are encouraged to save and not spend, thereby bringing demand in line with supply.
But there is another story and another way to bring about alignment: increase supply. The fact that there are too few goods relative to the demand for them is not simply because demand has increased, it has also come about due to supply side pressures. In recent history there was close to two years of no migration, supply chain disruptions as COVID swept through and impacted manufacturing and transport capabilities, climate damaged produce, the war between Russia and the Ukraine causing wheat, coal, gas, oil and metal prices to climb to new heights, and, more recently, the escalation of tensions in the Middle East.
Interest rate hikes are impotent to the inflationary impacts of supply side pressures, such as these. But that is not the same as saying that the government is helpless. It is not. It can grow Australia’s capacity to produce more. Indeed, it is imperative that it does. The most recent available data suggests that there is a mere 1.4 unemployed people per job vacancy advertised. While this represents a welcome improvement on the situation around a year ago where the ratio was one to one, it is less that half what it was pre-COVID and, as the chart below illustrates, it is historically low.
The number of unemployed per job vacancy is historically low
Note: The break in the chart reflects a suspension in the ABS’s job vacancy survey between May 2008 and November 2009.
To borrow a quote from the well regarded Australian economist, Chris Richardson: “Rising supply is a much happier solution to inflation than demand destruction”. That is, a better and more sustainable policy focus is to grow Australia's productive capacity through migration; supporting the labour force participation of women, mature aged workers and other under-represented cohorts; and measures designed to boost productivity. To give credit where credit is due, the former is the focus of the government’s Employment White Paper, and the latter, the Productivity Commission’s 5-Year Productivity Inquiry. I have more to say on the subject of migration at the end of this article.
3. There is a Non-Accelerating Inflation Rate of Unemployment
Just as men who dress up in red suits and black gumboots call themselves Santa are not really Santa, an unemployment rate labelled the Non-Accelerating Inflation Rate of Unemployment, or NAIRU for short, does not necessarily make it so.
Perhaps I am being a bit harsh and a little economic history is in order. The genesis of the NAIRU starts with New Zealand economist, Bill Phillips, who in the late 1950s demonstrated that there was an inverse relationship between unemployment and inflation. The theory is that strong demand both cuts unemployment and pushes up inflation, while weak demand exacerbates unemployment and cuts inflation. The graphical presentation of this trade-off became famously known as the Phillips Curve. This relationship held post the Great Depression when a little bit of inflation seemed like a small price to pay to get nations working again.
Phillips’ view was challenged in the late 1960s by Chicago economist, Milton Friedman, who argued that, if inflation persisted long enough, the expectations of workers and businesses would adjust. Inflation would become ‘baked in’ as workers and suppliers increased their wages and prices by enough to compensate for inflation, whatever the unemployment rate. Over the long term, he argued that there is a natural rate of unemployment – a floor – below which extra wages growth would simply lead to more inflation. The combination of high inflation and high unemployment in the early 1970s seemed to vindicate Friedman‘s theory, encouraging it to be adopted by monetary policymakers around the world, including the RBA in the form of the more clunkily termed NAIRU.
As at least one Australian economist has argued, the natural rate was a one hit wonder. The NAIRU has not been really tested again until now. As I argue further below, wages failed to grow in line with inflation as we emerged out of pandemic conditions. And while the RBA may wish to take credit for inflation now trending down, claiming that higher interest rates have been worth the pain, this does not stand up to scrutiny. In theory higher interest rates work to drive inflation down by reducing investment and consumption and, thereby, increasing unemployment. But inflation has fallen while the rate of unemployment has barely budged. An unemployment rate of 3.8 percent is a long way short of the RBA’s so called NAIRU of 4.5 percent.
Inflation is trending down not because of the RBA’s attempts to suppress our demands, but because the supply side of the economy is becoming less pressured. Inflation imported from overseas is easing, migrants are helping to fill supply gaps (more on this below), and so too are local workers who previously had not been active participants in the labour market, such as youth and women. This impacts both the numerator and the denominator of the unemployment rate and provides further pause for reflecting on why a target NAIRU is a nonsense.
As Alan Kohler observed in his special report delivered towards the end of February, this time it is different, the rules have changed. Measures that we have traditionally relied upon, such as interest rate spikes and wage constraint (refer next) will have little impact. They are hurting Australians, risking recession and may do little to bring prices under control.
Many will, therefore, be breathing a cautious sigh of relief that at its December 2023 Monetary Policy meeting the RBA board decided to keep the cash rate unchanged at 4.35 percent. It is too early to predict whether this is a turning point. But if it is, that would bring relief to mortgagees (discussed above) and provide a stimulus for business investment, much needed to drive productivity gains.
4. Wage increases risk driving inflation higher
The discussion under this header is unashamedly adapted and updated from what I wrote earlier in the year where I questioned Should we be waging a war on wages?
As inflation had been climbing there was much inflammatory commentary about the risk of a wage-price spiral should employers not exercise wage constraint. An example of this is an article which ran in the Australian Business Review mid last year. There the journalist would have had us believe that:
“… our economy now looks set for a wage explosion on the back of a substantial minimum pay rise and labour shortages created by overstimulation, lower immigration and Australians spending more money locally. The wage/price outlook is like a dry forest requiring only a small spark to create a raging inflationary bushfire.”
Well that certainly sounds very scary. But should we believe it? Should employers exercise wage constraint?
The first point to make is that while in the past changes in wages would appear to have loosely tracked price changes, the same cannot be said since COVID. In June 2022, when that article was written, the CPI was 6.1 percent and the Wage Price Index (WPI) was 2.7 percent, which equates to a large gulf of 3.4 percentage points. In other words, wage growth was not contributing much to inflationary pressures. From employees’ perspective what this means, however, is that they could not afford to buy as much as they had previously from their pay packets. Since then wages have continued to grow and inflation has come down. However, there remains a significant gulf of 1.4 percentage points.
Wage increases remain below price increases
Increase in the CPI and WPI in the previous 12 months, percent
Say, for arguments sake, employers do exercise wage constraint and maintains a gulf. Then what happens? Do the additional earnings that would have gone to workers magically disappear? And with it the threat of added inflationary pressure?
Of course they do not. What happens is that they inflate the profits earned by businesses. What does not get invested back into the business gets paid out to shareholders. Should we not be just as concerned about shareholder spending sending inflation spiralling out of control?
If we take a whole of economy look at what has been happening over time, there is a very clear trend of proportionally less of the total income earned economy-wide being paid out as wages and more being realised as profit. While the last couple of quarters have seen a reversal of these trends, it is too early to tell whether this will be sustained.
A growing share of income is going to profits, not wages
Wage and profit share of total factor income, percent
That said, regardless of whether income earned ends up in the hands of workers or shareholders, there is a leap in logic in assuming that it will fuel a price spiral of any description. While it may contribute to demand side pressures, as much of this article has laboured on, there is the too often forgotten about supply side.
5. Migration is driving up inflation
Some commentators, such as the author of this linked article that ran in the Financial Review, have posited that high migration has contributed to inflationary conditions. It is true that more people means more money chasing goods and services, which in the absence of more goods being produced and services provided, will drive up prices.
But that is only half the story. Migrants also produce the goods and provide those services that we demand, which helps drive prices down. This is why we have skilled migration.
As the Reserve Bank Governor comments, the net effect is unclear.
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