Inflation is at its highest in many decades but can we kill it without hurting ourselves, or will the Reserve Bank’s (RBA) battle with the inflation monster have collateral damage in the form of a recession?
Plenty of us now know that the interest rate rises we have seen this year have happened because the RBA is in charge of fighting inflation. They use interest rates to do so.
Higher interest rates are supposed to reduce inflation and lower interest rates are meant to lift inflation.
At the moment, interest rates are rising as inflation surges to record highs, as the next chart shows.
The 2 types of inflation
Higher prices can come from two places.
One is when there’s too much local demand. Imagine a plumber who gets six calls a day for jobs but only has time to do three jobs a day. He starts putting up prices until three of those people say, “Don’t worry, I’ll do it myself”.
That kind of price rise the RBA can do something about. It reduces households’ disposable income by raising interest rates so mortgage payments are higher.
This means fewer people call the plumber. “Let the tap drip,” they think. “We can’t afford to get that fixed this week.”
The plumber stops raising prices, inflation stops rising.
That’s domestic inflation.
But there’s another kind of inflation.
Imagine a tap company that sells imported taps to the plumber. They find the price of taps is going up because shipping costs more, and because the taps are made in Europe where energy prices are high.
Even if the tap company isn’t getting more calls from customers each day, they are raising prices because their input prices are rising. They can squeeze their margin a bit, but not much.
That’s imported inflation. And we have more of that than ever, as the next chart shows.
Historically our inflation was mostly about non-tradable goods like plumber services, but now it’s much more about tradables (like imported taps but, more importantly ,fuel).
The tradables component is not just imports, it includes things we export that have their price set on global markets, like gas and grain.
If the RBA is pushing down on the Australian economy, the non-tradables sector is the part they have their palms on.
The smaller it gets as a source of the inflationary pressure, the harder they need to shove it to make any difference to the overall price level.
And this is the risk. The harder they push down, the higher the risk they crush the economy.
In theory, higher interest rates should strengthen our currency and make imports cheaper, but when all central banks around the world are also lifting rates, that theory doesn’t work terribly well.
Our dollar is, if anything, lower against the US dollar now than it was at the start of the year, making imports from the US more expensive, not less.
The Americans use a different definition of recession, but it certainly shows the risk of raising rates very quickly – you can get a hard landing even before you make any headway on reducing inflation
US inflation is 9.1 per cent over the past year, far higher than Australia has seen so far.
RBA governor Philip Lowe has said we are on a “narrow path”.
The truth is it’s more like a tightrope walk. There’s lots of room for error on either side – do too little and let inflation run away, or do too much and see the economy suffer.
And the RBA is not the only player in the game. The new Treasurer, Jim Chalmers, is pledging to use the Budget to fight inflation too.
Let’s hope for a swift victory against the inflation monster.