Inflation is rising at its fastest pace in 20 years.
The value of a typical worker’s salary has been deteriorating since mid-2021.
How worried should we be? Will things get even worse?
It’s a conundrum for the Reserve Bank, but they want you to feel like you’re in control.
Caught off guard
The recent surge in consumer inflation took the RBA by surprise.
We haven’t seen inflation like this in the modern era.
Core inflation – which removes volatile price movements from the data to see the truer rate of inflation below – rose 1.4% in the March quarter.
This is the fastest quarterly price growth since the RBA started inflation targeting in 1993.
See graph below.
The range of goods experiencing notable price increases has also widened in recent months.
During the March quarter, about 70% of the goods in the consumer price index (CPI) “basket” had an annualized inflation rate above 2.5%.
We haven’t seen widespread price increases like this since before the global financial crisis.
See below.
So not only are the prices going up, but the price increases are spreading throughout the economy.
Here is where things stand now (end of March):
- Fuel prices jumped 35% in the past 12 months, the largest annual increase since 1990
- Construction materials prices are 15.4% higher than a year ago
- Durable consumer goods inflation is rising at its fastest pace in more than three decades (this category includes, among others, motor vehicles, furniture and household goods, as well as computers and televisions)
- Grocery prices (excluding fruits and vegetables) rose 2.8% in the quarter, the largest quarterly increase since 1983
- Fruit and vegetable prices are 6.75% higher than a year ago
- Rents increased 0.6% in the March quarter, the largest quarterly increase since the September 2014 quarter
- Tertiary education prices increased by more than 5% in the March quarter, due to the federal government’s decision to increase the cost of certain university courses
Has your weekly salary increased at similar rates?
I doubt.
The real value of your salary (adjusted for inflation) has probably deteriorated.
In fact, the RBA says real wages have been falling in Australia since mid-2021, and that’s hurting the poorest households the most.
“Cost of living pressures from rising food and fuel prices are likely to fall unevenly across households, as low-income households spend a greater proportion of their income in food and fuel and have relatively limited savings reserves to draw on,” the RBA said last week.
Which brings us to his decision to raise interest rates.
So where to go from here?
Last week, the RBA raised the cash rate target from 0.1% to 0.35%.
He said he did so in part because interest rates couldn’t stay at those emergency lows forever. Rates should start to return to more “normal” levels.
But he also raised the cash rate target because he’s concerned about people’s expectations.
He doesn’t want people to start expecting inflation to be higher in the future, because then people might start behaving as if it is higher.
What does that mean?
Well, if you think prices will continue to rise rapidly, you can become an activist to demand regular wage increases.
If you think the face value of your savings will deteriorate faster, you can change your spending and saving behavior.
On the business side, if retailers and wholesalers expect prices to rise faster in the coming years, how will this change their behavior?
What will he do with contracts in the construction industry?
The list continues.
This is why the RBA does not want people to think that it has lost control of prices.
So he started to raise the target rate to signal to people that he won’t let inflation take off.
Will it work?
Well, ignore the fact that economists say that rising interest rates actually contribute to rising price level.
And set aside the question, for today, of what rising rates might do to people’s job and salary prospects in the current environment.
Will the RBA’s decision to start raising rates help assure people that the pace of inflation will not continue to pick up in the years to come?
Currently, the short-term inflation expectations of households, union officials and market economists have already jumped.
The “short term” refers to where people think the rate of inflation will be 12 months from now.
See below.
However, their long-term inflation expectations have not increased to the same degree.
And from the RBA’s perspective, that means there’s still time to convince people that inflation won’t get out of control.
See below.
But how difficult will it be to calm inflation expectations without hurting households?
Could there be better ways to curb inflation without raising interest rates?
The optimistic way to reduce inflation
Dean Baker, senior economist at the Center for Economic and Policy Research in the United States, recently wrote about these issues.
He reflected on the fact that developed economies like the US, UK and much of Europe were experiencing similar levels of inflation.
He said the global supply chain disruptions that led to the initial pandemic-era price spike lasted longer and were greater than he had anticipated, and that was in partly due to successive waves of coronavirus washing around the world.
He said the other source of disruption was Russia’s invasion of Ukraine, with its serious impact on food prices and oil and gas prices.
“The idea that inflation would soar under such circumstances should come as no surprise,” he said.
“The normal delivery of goods and services has been disrupted by the pandemic.”
But, when asked how policymakers could bring inflation down in the United States, he said there were two possible paths to take at the moment – one good, the other bad.
“The optimistic path to reducing inflation would be to end the supply chain issues that have been pushing inflation higher,” he said.
“It means an end to backlogs at ports, an end to trucker shortages, and an end to COVID-19 related shutdowns in China and other manufacturing locations.
“Furthermore, the return to services will reduce the extent to which the demand for goods exceeds the capacity of the economy to supply them.
“The story would be that when these disruptions were over, or at least improved, the prices of many items would stop rising and even come back down. That shouldn’t seem like a stretch.”
The other possible path would be a bad story, he said.
“From that perspective, we are already seeing a wage-price spiral,” he said of the US economy.
“High inflation is changing people’s expectations, with workers now seeking higher wage increases to compensate for the high inflation of the previous year.
“A series of wage increases that offset last year’s inflation will put upward pressure on prices. This sequence continues, with inflation rates reaching increasingly unacceptable levels.”
He said that in the 1970s high inflation in the United States was finally broken by the decision of the Federal Reserve to raise its overnight interest rate above 20%.
This led to a deep recession in 1981-82, with the unemployment rate peaking at over 11%. This eventually brought inflation down, but it caused enormous suffering for millions of people.
“This point is important to keep in mind,” he said.
“There is no easy, painless way to bring down the rate of inflation through rate hikes by the Fed.”
“There is no easy way to solve this problem,” he concluded.
Can Australia reduce inflation painlessly, or will it be impossible?
With two weeks to go before the federal election, the major parties haven’t spent much time talking about it.
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