investigation
Inflation 101: John Flint explores our inflation problem, how we can fix it and how close we are to recession

How do you tame a dragon called inflation without burning down the entire kingdom in the process? That is the conundrum facing Australia, in particular, the Federal Government and the nation’s central bank — the Reserve Bank of Australia. The outcome and battle scars of this dragon-slaying quest will impact pretty much everyone, even if it’s the mortgage-carrying infantry that has been bearing the pain burden so far. The fate of the economy - our prosperity and living standards - rides on it. We haven’t seen inflation this high for three decades, so it’s an entirely new experience for younger Australians. John Flint breaks down the challenge so that readers don’t need an economics degree to understand what the boffins are talking about. So what actually is inflation? Inflation is very simply the rate at which the prices of goods and services rise. When inflation is high, our money buys less and our wages don’t go so far. Inflation is measured via the Consumer Price Index (CPI), which shows the percentage change in the price of a basket of goods and services typically consumed by Australian households. The Australian Bureau of Statistics (ABS) has the job of calculating the CPI. It does so by collecting the prices for thousands of items, which are grouped into 87 categories and 11 groups. The items are chosen according to up-to-date research on how people are spending their incomes. Some items, like housing, are afforded a higher weighting because more of our income goes on that than, for example, buying new clothes — for most of us, that is. Every three months, the ABS calculates the price changes of each item from the previous quarter and aggregates them to work out the inflation rate for the entire CPI basket. The CPI, based on the latest figures in March, is currently 7 per cent. It is down from 7.8 per cent in December. The Reserve Bank (RBA) also publishes a monthly indicator based on updated prices for around two-thirds of the items included in the CPI basket. The latest monthly indicator has inflation at 6.8 per cent. The target range we want to get to is 2-to-3 per cent. Prior to the pandemic in December 2019, the CPI was just 1.8 per cent. Inflation is a menace in many parts of the world right now. Spare a thought for Argentina, where inflation has reached an eye-watering 114 per cent. With our 6.8 per cent, Argentina definitely isn’t crying for Australia. Economists break inflation down into three types, which can push prices up concurrently or in isolation. The first is what is termed demand-pull inflation. This is when the demand for goods or services rises faster than the supply of those goods and services. The second, cost-push-inflation, is when prices go up as a consequence of production costs increasing, including a higher cost of materials or labour costs. The third is a self-fulfilling prophecy - inflation expectations. What households and businesses think will happen to prices in the future can influence actual prices in the future. Inflation expectations can prompt businesses to put up prices or workers to demand pay rises, as well as nudge consumers to purchase big items they’ve got their eyes on, like a brand new TV or fridge, sooner rather than later. These all have a knock-on effect. What or who is to blame for Australia’s bout of high inflation? There is no single bogeyman. Several causes conflated to push prices up. Pandemic-related supply constraints, Vladimir Putin’s invasion of Ukraine and the impact it had on energy prices, government stimulus measures, corporate profiteering and other factors have all played a hand in inflation, which took off from mid-2021, taking the Reserve Bank and other forecasters by surprise. So far, wage increases haven’t tipped fuel on the fire, even if the Reserve Bank is worried they will. New research by the RBA, published this week, pinpoints supply-side factors as “the biggest driver of recent inflation outcomes in Australia.” “Supply-side factors included: disruptions resulting from the COVID-19 pandemic, which strained the ability of firms globally to produce and deliver goods; Russia’s invasion of Ukraine, which led to sharp increases in the prices of energy and other commodities; and flooding on the east coast of Australia in the first half of 2022, which interrupted domestic supply chains,” the researchers stated. The manufacturing industry, in particular, was deeply impacted by supply shortages from China, which dragged on because of the extended lockdowns there. “In the absence of supply-side shocks ... underlying inflation would have been around 3 percentage points lower in December 2022, or slightly below 3.5 per cent,” the Reserve Bank economists calculated. “As such, inflation would still have been above the Bank’s target range of 2–3 per cent.” Demand-side factors made up the rest, they reported. These included: an initial shift in demand from services towards goods due to pandemic-related restrictions on activity and a hesitancy among the population about going out and participating in social activities. They also cited the rapid economic recovery following the development of vaccines and the financial support provided to people and businesses during the pandemic, which pumped money into the economy. With record low interest rates during the pandemic, dipping to 0.1 in November 2020, Australians had amassed $240 billion in savings by 2021. And when restrictions eased, they wanted to spend with a vengeance. The RBA economists noted inflation within Australia’s overheated housing sector “accounted for a share of the pickup in inflation to date ... reflecting a combination of higher prices for imported construction goods and supply constraints in the construction sector”. The building stampede was fuelled by generous grants from the Morrison Government. In WA, demand was turbo-charged by additional building bonuses provided by the State Government. The RBA, which is responsible for Australia’s monetary policy, has been criticised for not attacking the problem earlier, waiting too long to begin lifting interest rates. Interest rate rises work by depressing demand for goods and services and letting heat out of the economy “They should have acted earlier and raised rates over a longer period in smaller increments, Peter White, managing director of the Finance Brokers Association of Australia, said. Economist Nicki Hutley said Australia was slower than other countries to react. “In late 2021, there was very much a kind of ‘everything’s fine, nothing to see here (attitude),” she said. “And then it all went very quickly to ‘Oh, my God, everything is not fine.‘ Central banks around the world didn’t get this right. But others responded more quickly, including our New Zealand friends across the ditch.” Several economists have accused businesses of contributing to inflation by opportunistic profiteering. A recent OECD analysis found profits have been the leading component of recent inflation in several countries, including Australia. Dr Jim Stanford, Director of the Australia Institute’s Centre for Future Work, said the OECD research was consistent with its own. “Companies in Australia and many other industrial countries have taken advantage of the disruptions, shortages, and desperation of the pandemic to push up profit margins far beyond normal levels,” he said. “The RBA continues to ignore the role of profits in driving prices, while doubling down on its determination to suppress wage growth,” Dr Stanford said. “The undeniable reality is that profits are at all-time record levels in Australia, while workers’ real wages continue to decline.” The tourism sector, led by Qantas, has seen its profits soar as has the banking, energy and resources sectors. Last month, Telstra announced it be increasing its mobile and data charges in line with CPI and rounded to the “nearest dollar”. Is the telco doing it tough? Hardly. In February, it announced its profit had jumped by 25.7 per cent to $934 million. Australia’s supermarket duopoly of Coles and Woolworths has also been accused of increasing prices higher than necessary. Rod Sims, who retired as chairman of the Australian Competition and Consumer Commission (ACCC) last year, said their market power meant they could put up prices, without worrying about losing customers. Both companies deny price-gouging. RBA Governor Philip Lowe has downplayed talk of a profit-price spiral. “When we look at the aggregate data, the share of national income that is going to profits, if we put aside the resources sector, really hasn’t changed,” he told the Senate Economics Legislation Committee on May 31. “If profit margins were systematically widening across the country, we would see that in the aggregate data. There are certainly some firms where profit margins are rising but there are other firms where profit margins are under pressure. Construction is a good example of that but there are others are well. When we look right across the economy, the profit share, outside resources, hasn’t changed. Are repeated interest rate increases justified? The global supply pressures, that helped get us into this mess, are easing. What then is the wisdom of continuing to ratchet up interest rates, when the inflation trend, here and overseas, is downward? This month’s interest rate rise was the 12th to occur since May 2022. The only reprieve was a brief pause in April. Apart from unfairly squeezing the 35 per cent of households with mortgages and the 31 per cent of renters who cop further rent increases, more interest rate hikes risk tipping the economy into recession. The country is on a tightrope walk to get to the inflation target range. Every interest rate rise is a sharp tug on the rope that can send the economy into free fall. Dr Lowe this month described his high-wire act as navigating “a narrow and bumpy path”. Nicki Hutley, who is the president of the NSW branch of the Economics Society of Australia, is among economists urging refrain. “My sense is that the (RBA) board missed the boat, the first time on inflation, and now they’re kind of overcompensating for that and going well, ‘we’ve got to do everything’. Obviously, you have to do something about inflation, you can’t let it run away.” She said not all the causes of this inflation, like energy prices as a consequence of the war in Europe, could be addressed by increasing interest rates at home. “It’s looking at what’s within the realms of possibility for monetary policy to actually address and then how much tightening we’ve already had that you might want to wait just a couple more months, to see where it’s going,” she said. “There’s no doubt that you can get aggregate demand down (with further interest rate rises). I mean, consumer demand only increased by 0.2 per cent in the March quarter as it was, it’s not like overall we’re spending a lot of money. “The question for me more is, what are the things like energy prices, like supply chains ... You can keep banging the hammer but the nail won’t go in any further because monetary policy is not what controls those things.” Interest rate increases don’t influence the spending of those who don’t have to worry about them because they’re debt-free. Not everyone is having to switch to home brands and shop for cheaper cuts of meat. A Commonwealth Bank report last month showed older Australians are increasing their expenditure while younger customers are cutting back. Its Cost of Living Pressure Indicator also showed renters were hardest hit. A third of the bank’s mortgage holders had savings buffers of two years or more. Dr Lowe has acknowledged that the prices of oil, base metals and wholesale foods had almost returned to normal in global markets, as had international shipping, but he was still spooked about domestic inflation triggers. He intimated the board wouldn’t baulk at more interest rate increases if they felt it was warranted. “The board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that,” he said. “If we had not tightened monetary policy, the cost of living would be higher for longer. This would hurt all Australians and the functioning of our economy and would ultimately require even higher interest rates to bring inflation back down. So, as difficult as it is, the rise in interest rates is necessary to bring inflation back to target in a reasonable time frame,” he added. How does the inflation crisis intersect with the housing crisis? Interest rate increases are aggravating the housing crisis and not just through the extra misery they’re heaping on mortgage holders and renters. High interest rates make it harder for investors to borrow. Apart from discouraging would-be investment property owners, they force many landlords to terminate leases and sell up, reducing the stock of properties for rent. Vacancy rates are at record lows and rents in Perth have gone up 17.3 per cent in the past 12 months. Increasing rents also force up the CPI, which in turn puts pressure on the RBA to lift rates again. Housing is the highest weighted group in the CPI, accounting for around one-quarter of the basket. It includes new dwellings purchased by owner-occupiers, rents and major renovations. Home prices have been climbing for three straight months, also putting upward pressure on the CPI. This was likely due to a shortage of new homes. In WA, landlords have started locking in two annual rent increases in new leases prior to changes to the Residential Tenancies Act that will limit them to one per year. Ironically, the artificial house building boom, created by government pandemic stimulus measures, helped ignite the inflation crisis. “The building sector was where it first sparked off because that was a sector that was so overstimulated,” Ms Hutley said. “It was absolutely stupid policy. It was not necessary and there was no indication at the time that it was.” The industry’s insufficient capacity to meet the explosion in demand meant construction times dragged out for three years and longer, putting customers into situations where they were paying mortgages and rent at the same time, in addition to contract variations caused by the soaring prices of building materials and labour. Why can’t the RBA do something else instead of raising rates? Call them one trick ponies if you like, but the RBA is limited in what it can do. Monetary policy involves setting the interest rate on overnight loans in the money market — the cash rate. If the cash rate is raised it will cost more for banks to transfer money between themselves. That is recouped by passing on the extra costs to consumers, via rate rises. Cash rate increases don’t just affect borrowers, they exist for savers too. But the effectiveness of monetary policy is weakened when banks are slow to reward savers or don’t pass on the full amount. Dr Lowe said he hoped an inquiry by the ACCC into how banks set interest rates for savers, will pressure them to lift their game. “The banks are very quick to pass on (cash rate decisions) into loan rates, but most of them are very slow to pass on to deposit rates, and they need to do better there,” he said in February. Dr Lowe also encouraged consumers to switch banks. “If Australians switch, then the banks have to respond. If there’s competition, firms have to respond,” he said. What else can be done to tame inflation? The Federal Government has its own role in curtailing inflation, via its fiscal policy — tightening spending when it wants to cool the economy and doing the opposite when trying to spur activity. Ms Hutley said the recent Federal Budget could have gone further but was fiscally responsible. The Federal Government can implement measures to boost competition and combat anti-competitive behaviour but such actions don’t translate into lower prices overnight. Increasing productivity also puts downward pressure on prices. But making workers more productive often requires investment in innovation and technology, which high interest rates typically discourage. The Government can use tax breaks and other measures to boost investment in these areas. Dr Lowe has warned that wage gains have to be matched by productivity gains to avoid wage-push inflation. Ms Hutley believes fears of an imminent wage-price spiral are overblown. “He’s worried that once you get inflation entrenched and everybody’s expectations rise, then that starts to flow through into a vicious wage price spiral,” she said. “But there is no evidence that is happening. Wages have been so constrained. Given the tightness of the labour market it is quite remarkable.” There have been calls for the scrapping of next year’s Stage Three tax cuts, with some economists describing them as inflationary and irresponsible in the current climate. Are we headed into recession? Following the most recent rate rise, Treasurer Jim Chalmers said it was the RBA’s job to “squash inflation without crashing the economy”. But a crash is getting harder to avoid, say economists. “The language we’re getting now is back to ‘the recession that we had to have’. And I’ve seen that phrase bandied around a few times in the last couple of days,” Ms Hutley said. “For those of us that actually lived through ‘the recession that we had to have’, you don’t ever forget that. What stands out is that even in a short recession, the scarring that takes place, you’re talking five to seven years, even in a mild recession. “When unemployment rises like that, it doesn’t come down quickly. We talk about numbers, but there are faces behind all of these numbers. Ultimately, these are people’s lives that are being messed up. I’m really worried as to (the RBA’s) mindset of let’s go at inflation at all costs, because the costs will be very high. “I think there’s some interesting commentary around New Zealand having gone into a technical recession, off the back of two negative quarters of GDP, but with unemployment still below 4 per cent. And, you know, that’s not a (real) recession. Look back at earlier days, when there was 8 per cent or 9 per unemployment, that’s what a recession looks like. “Even if unemployment only rises to four and a bit per cent you’re still talking a couple of hundred thousand people who are going to lose their jobs. That’s not insubstantial. But it still doesn’t look like the nastier recessions that we’ve had. “I suspect that if they want to get inflation down really quickly, the only way they’ll do it is with further interest rate rises. And that will induce some sort of a recession ... We will definitely have higher unemployment. How ugly it looks is, it’s still a bit questionable at the moment.”

investigationInflation 101: John Flint explores our inflation problem, how we can fix it and how close we are to recession

investigation
Inflation 101: John Flint explores our inflation problem, how we can fix it and how close we are to recession