U.S. inflation has hit a three-decade high in October, with consumer prices rising by 0.9 per cent. Inflation has been fuelled by a consumer price surge in food products, petrol and a sluggish global supply chain.
The U.S. Consumer Price Index rose by 6.2 per cent in October year on year, the most significant jump since 1990.
In 2020 and 2021, central banks worldwide lowered their cash rate to save their nation’s economies from the pandemic. As a result, many experienced inflationary pressure not seen in decades. So the question is, will Australia follow?
What causes inflation?
Simply put, inflation occurs when there is too much money chasing too few goods. When more money enters the economy, through increased wages, for example, individuals are willing to spend their increased income. As there is now more competition for goods, prices are pushed higher, and inflation occurs.
Central banks have some power to control inflation,through the cash rate they set. The cash rate is the rate of interest a central bank charges a commercial bank. When the cash rate is low, commercial banks are encouraged to lower their interest rate; when the cash rate is high, they are encouraged to raise their interest rate.
High interest rates not only discourage lending but also capture a larger portion of the borrower’s income. The reverse is true for low interest rates. By manipulating interest rates, central banks, such as Australia’s RBA, have some power to control how much money is in circulation and how willing the population is to spend.
William McChesney Martin, longtime Chairman of the U.S. Federal Reserve, famously summarised the role of the central bank as being to “take the punchbowl away before the party gets started”.
So if central banks can control the economy in this way, what has happened in the U.S.?
Supply-side inflation
Central banks have the power to address too much money, but not too few goods. Global supply chain failures have made headlines worldwide and have been particularly impactful on the U.S. Powerful as they may be, central banks have no power to address issues in the supply chain.
Supply chain issues have caused a decrease in the availability of goods. When too few goods cause inflation, economists refer to the situation as “supply-side inflation”. Supply-side inflation is a rare occurrence. The world’s complex supply chains have rarely broken down in the past decades.
The pandemic has caused interruption to global supply chains. However, at the same time, central banks and governments worldwide have been aggressively stimulating economies, encouraging both businesses and households to spend big.
Realistically, a combination of both too much money and too few goods is causing U.S. inflation. However, experts are more concerned about supply-side inflation, as there is little they can do to influence it.
One option central banks have is to constrict the economy to ease pressure on supply chains, but this would undermine their purpose in the long run, which is to see unemployment rates as low as possible.
Low unemployment generates wage growth and more robust demand, which nations need to recover from the pandemic. Strengthening monetary policy by increasing the cash rate to address the current supply shock would risk this objective.
What about Australia
So what does all this mean for Australia? Are we likely to follow America’s lead?
Well, not just yet. In the years after the 2013 mining boom, the RBA kept what many economists perceived as “too tight” of a hold on Australia’s economy.
Macro-economic policymakers set policies that didn’t stimulate the economy, in an effort to avoid inflation. However, in hindsight, the strict policy settings resulted in unemployment being consistently above the actual “non-accelerating-inflation rate of unemployment” or NAIRU.
NAIRU is the rate at which wage growth will not cause inflation. The theory of the Phillips Curve suggests that there is an inverse relationship between the rate of wage growth and the unemployment rate. The lower the unemployment rate is, the faster wages growth is likely to be.
Following on, this theory suggests an inverse relationship between price inflation and unemployment and the notion that there is a ‘trade-off’ between the two.
Australia’s high unemployment rate has had a lasting effect on the economy and resulted in meagre wage growth in Australia over the last eight years. Interestingly, Australia’s ineffective policy settings may save the country from experiencing the inflation seen in many countries.
Australia’s labour market hasn’t been and remains not ‘tight’ enough to give workers sufficient bargaining power in relation to employers to extract wage rises. This means, moving forward, Australia has more wriggle room to stimulate the economy post-pandemic without risking significant inflation.
However, as with all things economic, NAIRU and inflation are hard to predict and cannot be observed until they are staring an economy dead in the face. Only time will tell if Australia will avoid post-pandemic inflation.
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