The RBA is making confusion about inflation and the cost of living even worse
There’s a paradox about the way we respond to threats to the cost of living.
On one hand, governments put in place subsidies for things such as rent and electricity, as the federal government did in this year’s budget.
On the other hand, we get told these subsidies are inflationary because they put more free cash in the hands of consumers.
At the same time, when the cost of living climbs enough to push inflation beyond the Reserve Bank’s target, the bank pushes up interest rates in an attempt to drive measured inflation down.
For mortgage holders, this often pushes up payments. which aren’t included in the standard measure of inflation but nevertheless add to their cost of living.
By themselves, higher prices aren’t a problem
Although we often talk about the cost of living as a problem, by itself it shouldn’t bother us much.
The cost of living, as measured by the amount needed to meet basic needs, has been climbing steadily for at least a century.
In the famous Harvester judgment of 1907, Justice Henry Higgins determined that a “living wage” for a family of five was 42 shillings ($4.20) per week.
So much has the cost of living climbed that these days that can barely buy a cup of coffee.
A loaf of bread cost four pennies then, and these days costs 100 times as much.
Yet no one doubts that the typical family is better off today even though the cost of living has climbed.
The reason, of course, is that incomes have climbed faster than prices for most of the past century.
Average weekly ordinary time earnings are now nearly $2,000 a week, 500 times higher than in 1907.
What matters is not prices, but the purchasing power of our disposable incomes (which are incomes after the payment of taxes, interest and unavoidable costs).
Just recently, and unusually, wage growth has been lagging behind price growth. In 2022, the year in which inflation peaked, consumer prices climbed 7.8% while wages grew 3.3%.
The 2022 increase in prices wasn’t at all extreme by historical standards. Prices climbed faster in the 1970s and 1980s without producing a “cost of living crisis”.
But back then, during much of the 1970s and 1980s, wages were indexed to prices, meaning they kept pace. As a result, increases in the cost of living didn’t worry us as much.
Sharp interest rate increases are a problem
The response of the Reserve Bank and other central banks to the inflation shock of 2022 was to rapidly and repeatedly lift the interest rates they influence, the so-called cash rate in Australia’s case, in order to drive inflation back to target.
It is important to observe that no theoretical rationale for Australia’s inflation target has ever been put forward.
Both the idea of targeting consumer price inflation and the choice of the 2–3% target band are arbitrary. They were inherited from the very different circumstances of the early 1990s and the judgment call of a right-wing New Zealand finance minister.
The recent review of the Reserve Bank acknowledged the challenges to this orthodoxy but didn’t consider them.
A more fundamental problem, which hasn’t been properly analysed, is the relationship between high rates and the purchasing power of disposable incomes.
Higher rates benefit some, hurt others
Interest payments are a deduction from disposable income for households with mortgage debt (mostly, but not exclusively, young) and a source of income for those with net financial wealth (mostly, but not exclusively, old).
The result is a largely random redistribution of the effects of increasing interest rates. It’s perceived by the losers as an increase in the cost of living, and by the winners as a windfall gain, enabling some luxury spending.
I made this point about the limitations of using interest rates to contain inflation at a Reserve Bank conference in the late 1990s, but it had little impact at the time.
Since interest rates remained largely stable around a slowly declining trend for the following two decades, the point was mostly of academic interest.
Until now. The increase of about four percentage points in the Reserve Bank’s cash rate from 2022 is the first really large increase since the inflation target was adopted in the early 1990s.
We are now seeing the consequences of using interest rates to target inflation, even if they are poorly understood.
Fitting in with familiar narratives, the distributional consequences are framed in terms of intergenerational conflicts (Boomers versus Millennials) rather than the product of misconceived economic policy.
If sharp increases in interest rates aren’t the right tool to control inflation, what is? The experience of the 1980s provides an idea.
The best idea is to avoid income shocks
Rather than seeking a rapid return of inflation to an arbitrary target band, we should instead focus on avoiding large income shocks while bringing about a gradual decline in inflation.
That would mean indexing wages to prices, and avoiding sharp shocks like the interest rate hikes in the late 1980s that gave us the “recession we had to have”.
That’s unlikely to happen soon. In the meantime, it’s a good idea to try to avoid the traps inherent in talking about the “cost of living”, and be aware that in a world in which the actual cost of living includes interest rates, sharp increases in rates do little for many who are finding it hard to keep up
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“The recent review of the Reserve Bank acknowledged the challenges to this orthodoxy but didn’t consider them.“
I and a number of colleagues coordinated a write-in to the RBA review that year, all taking different aspects of the RBA's economic and organisational dysfunction into account. However, the reviewers assigned by our Treasurer, Jim Chalmers, ignored all our work.
I know the environment as I used to work for the Reserve Bank back in 2001, reversing the outsourcing of the computer systems that manage our nation’s Exchange Settlement Accounts (ESA) System for the private banking reserves. So, I have worked for the Reserve Bank, and I will say that it was one of the better workplaces I have worked in, certainly at the technical level. The immediate IT management in that organisation was superb, and it was a pleasure to work there. Still, the Financial Senior Management Board and their devotion to neoclassical (and neoliberal) ideology leave much to be desired. I just wanted to clarify the distinction, so nobody thinks I am a disgruntled ex-employee. It was a great job, and I regret not taking up their permanent employment offer. Still, I was hoping to get married (I hadn’t proposed at the time I left, but knew I had found the one — and did so before taking up the next job), and the wage drop to take on permanent work from contracting was significant. Personal guff aside, I spent a good 14 months in that job, and we successfully reversed the previous outsourcing, which involved creating a reverse-engineered alternate system for the nation’s banking reserve system, which at the time handled between $9B to $16B worth of transactions a day. I wrote the operational support and security interface systems for internal staff on the Alpha network we rebuilt in-house.
After I realised our Treasurer, Jim Chalmers, was not paying attention to our collaboratives' multiple letters, I published mine in AIMN. This was noted by John Herman (editor of ERA), who asked if he could republish it in ERA. After some peer review assessment and the usual requests for expanding explanations, rewording, etc. (which only made it larger), they published it in two parts.
It explains how monetary policy “Changes in interest rates can have a reverse effect on inflation.” https://era.org.au/monetary-and-fiscal-policy-frameworks-for-australia-part-1/ Part 2 describes a little more about how money is created (just change the “1” to “2” on that URL to read part 2). It also is a tad critical about the Board’s makeup and their devotion to neoclassical ideology, which has no basis in the reality of how interest rate can possibly affect cost-push inflation (or, for that matter, measure unemployment - but that is another story).
Normally, when I find myself disagreeing with you, John, it means I have to check my logic and assumptions to see where I went wrong, but in this case I might actually disagree.
The simplest problem I have with your analysis is you're saying the distributional effects of a policy are an argument against pursuing it. That's never the case, because distributional effects can always be corrected by simply taking money from the rich and giving it to the poor. If high interest rates favour the rich over the poor, just tax the rich and give more to the poor. By making the RBA responsible for financial stability and equality, you're setting them an impossible task.
My second issue relates to time frames - the current crisis is a result of decades of policy failure and would take decades to unwind (if anyone were serious about unwinding it). If we fall into recession it will be the result of fiscal and policy irresponsibility, not the RBA being a percentage point or two off the mark. Even the blame for the ludicrously low interest rates of a few years ago falls mainly to Coalition governments unwilling to implement appropriate fiscal policy.
Finally, I think moderate interest rates are a good thing. The fact asset prices are so absurdly high is because of the abundance of cheap money over the last three decades. We can't keep accelerating out of trouble without ever touching the brake. Maybe there are better tools for clawing back that excess cash, but they don't belong to the RBA. They're in the hands of the government and the Coalition long ago lost interest in doing the hard stuff and now Labor has got sick of being the responsible parent, so it's left to the RBA - the primary school teacher in this analogy.