Inflation is always and everywhere a monetary phenomenon.
Milton Friedman, 1968.
‘Inflation’: A disproportionately large and relatively sudden increase in the general price level. Inflation may occur when the quantity of money or deposit currency in circulation is large compared with the quantity of goods and services offered, or when, because of a loss of confidence in the national money on the part of the public, a general and widespread attempt to convert money into commodities is precipitated. A normal increase in the price level after a period of deflation is generally not regarded as inflation.
‘Deflation’: A decrease in the general price level. Deflation may occur when the quantity of money or deposit currency in circulation is small compared with the quantity of goods and services offered, or when the fear of failure or some other cause curtails consumer spending materially, thus reducing the velocity of circulation.
‘Reflation’: Inflation or deflation of the currency in order to restore a former price level.
‘Disinflation’: A term recently coined to indicate a planned reduction in the general price level, so administered that the economy is benefited by increased purchasing power and not harmed by drastic deflation.
Sloan and Zurcher’s Dictionary of Economics, 1961 – cost twenty-two shillings and sixpence (decimal currency arrived in 1963). We wonder what this book would sell for in today’s inflated dollars. When purchased, our editor’s weekly wage as a junior accountant and part-time university student was 17 pounds.
Outsourcing of interest rate policy is an epic experiment whose longevity remains uncertain. Politicians do not usually surrender power. This surrender was based on two ideas: A recognition that central bank management might lead to a longer growth cycle; and a calculation that letting the Bank, not governments, determine interest rates might work in the long-run favour of politicians.
Paul Kelly "The March of Patriots, the Struggle for Modern Australia", October 2009.
As long as governments control money supply there will always be booms and busts. I became almost cynical as I watched an avowed gold standard and laissez-fair advocate, Alan Greenspan, take the chairmanship of the Federal Reserve Board and turn into an expert at saying nothing with far too many words – the hallmark of every ‘good’ politician.
Victor Sperandeo’s, "Trader Vic – Methods of a Wall Street Master", 1991.
ECINYA OVERVIEW
One of our readers asked us to write a piece on inflation and though we have commented sporadically on this topic over the past decade, we have never devoted an entire article to it. We thank Neddie Seagoon for his interest and contribution.
A bit of inflation is a good thing as it denotes a restoration or continuation of price stability. Note here that price does not equate with value, divergences occur for all manner of reasons. One of the central premises of economics is that demand and supply determine prices. Shortages generally mean higher prices and excess supply generally means lower prices. Always the major caveat is government interference in the market place that can cause supply distortions, demand distortions, and even price distortions.
In relation to the price of labour – wages – we can have mandated minimum wages, taxes on wages such as compulsory superannuation (a good thing) and payroll tax (a bad thing), an increase in unemployment benefits leading to a greater demand to become unemployed, immigration leading to an increase in the supply of labour, education leading to an increase in the quality and vocational diversity of labour etc etc. Mr Dixon of Qantas has recently demonstrated that a timid, benign and short-sighted board of directors can mandate unreasonable remuneration. How fortunate have we been that Allco did not succeed in their takeover aspirations, so warmly recommended by the then Chief Executive and his then Chairperson.
Our conclusions:
- Some inflation is better than none.
- In an era of excess capacity it is difficult to see inflation as a problem, but trade embargoes or other impediments can qualify this conclusion.
- Deflation is awful and words and happenings like recession, slow-down, and depression appear to be sinister sisters or belligerent brothers.
- Growth, recovery, are congenial companions to measured inflation.
- Inflation needs to be managed and probably a target of 1-2% is appropriate in an at-trend-growth economy.
- Growth above 3% is near enough to trend for Australia and most developed economies.
- Inflation needs to be always looked at in context, and such matters as education, tax policy, and employment policies do matter.
- Governments cause more inflation than do most central bankers.
- Our Federal election cycle is too short, leading to misallocation of resources and poor policy formulation and execution.
- Always trust falling interest rates to begin a new bull-market.
- A lot of official figures on inflation and other macro variables are ‘rubbery’ and comparison between countries is often biased in favour of the position being argued.
THE THREE FACES OF INFLATION
…. are an increase in the price of goods and services, an increase in asset prices, and the trade deficit impact on the current account deficit. Goods and services inflation is mainly expressed via the consumer price index, where a basket of goods and services is used to monitor changes in the inflation rate.
Asset price inflation applies to assets such as equities and housing. The trade deficit relates to the fact that importing a good or service can be perceived, or actually be, cheaper than producing the same good or service locally. Ecinya believes that not enough attention is focused on import replacement because exports are ‘sexier’ and manufacturing would require some robust economic decisions.
Just today we have been informed that meat and vegetable prices are falling because of the current appreciation in the $A . SOT, an Ecinya confidant (as is Neddie), often points out that there is rich man’s inflation and poor man’s inflation. SOT is so wealthy that things like international air-fares and classy restaurants bother him. He recently took advantage of a cheap flight to the UK because he could buy one ticket and get one free. Relative frugality has enabled Sot to prosper. As an example of his frugality and patriotism, he has always driven a General Motors vehicle and spurned the imported toys of BMW, Mercedes, Rolls etc although his wife recently purchased a Mercedes sports car, but our guess is this was to allow Sot to play golf in England and Scotland on his recent overseas adventure. We mention these things because the easy way to avoid inflation is to buy cheaper, or not buy at all, or spend your holidays overseas on a relative-value basis. So that in many ways, inflation is something of a choice.
Similarly, with house purchases: Houses are more expensive often due to location such as near the sea or in a highly regarded suburb. Fashionable housing in the Southern Highlands was selling at a premium, until recently. But even affordable housing is made more expensive by taxes such as the GST, stamp duties, and delays in construction due to the council approval process. Also, governments influence the availability of housing via re-zoning changes. The cost of living away from a workplace adds another dimension to goods and services inflation with higher travel costs. As populations increase, road infrastructure has to be paid for from higher traffic fines and other forms of taxation such as road taxes on transport vehicles and even income taxes. An inflationary increase in the price/ value of housing does not automatically add to either more housing or more wealth. More often than not, it just adds to the cost of housing as mortgage rates increase or slow-down the housing price appreciation. Given that housing is generally a major asset, house prices impact markedly on consumer and voter psyche. Those with low, or no, mortgage houses feel advantaged. Those with high mortgage housing, or no house at all, feel disadvantaged.
In relation to the trade deficit the obvious examples are Japan in the 60’s and 70’s where low-quality exports were replaced by high-quality exports as their skill levels and product development skills improved and America gave up its desire to manufacture. We all know the story of Honda, Toyota, Panasonic, Sony, Seiko, Mizuno, etc. In the 90s China has replaced a lot of our local manufacturing in basic household items such as ironing boards, kettles, TV screens, clothing, stationery, books, glassware, furniture, mobile phones, computers etc. A job lost in Australia is often a job created in China, or elsewhere. In looking at the deflationary impact of cheap imports we do not seem to analyse the reduced consumption levels at home, the taxes paid by manufacturers, and the compensation paid to unemployed workers. Additionally, certain social costs often derive from a pool of unemployed workers such as drug dealing, gambling and crime. Yesterday the Japanese-owned tyre manufacturer, Bridgestone, which has received 20 years of government support, closed down in Adelaide and 600 jobs have been lost. Bridgestone produced a quality tyre, and no doubt its viability has been impacted by imports.
THE ECONOMY THAT WE LIVE AND WORK IN
….is not the inflation adjusted economy.
Real Gross Domestic Product (GDP) is nominal GDP reduced by the inflation rate. Nominal GDP is the world we inhabit and is the source of profits and wages, and after unavoidable costs, of disposable income. Disposable income drives our consumption and our savings. Aggregate savings are used to drive investment. Savings can be public or private. Australia over recent years has had a domestic surplus which has facilitated infrastructure spend and reduced personal tax rates and helped keep interest rates at appropriate levels.
CENTRAL BANKERS AND INFLATION
Saul Eslake, ex-ANZ, and now with the Grattan Institute, published a paper titled "Inappropriately low interest rates are as dangerous as inappropriately high ones" in The Age newspaper on 17 September 2009. In part, he said:
"The global financial crisis had many causes, but among the more important of them was that the US Federal Reserve under Alan Greenspan, and his counterparts at central banks in other major advanced economies, kept interest rates too low for too long in the aftermath of the mild recessions which followed the collapse of the internet bubble at the beginning of the present decade."
"The mistake was not in cutting official interest rates to what were, at the time, unprecedented lows after the ‘tech wreck’ and the terrorist attacks of 11 September 2001. Rather, the mistake was in keeping interest rates at the levels struck in response to those events until as late as November 2003 in Britain, August 2004 in the United States and December 2005 in the Euro zone, long after the requirement for unusually low interest rates (to counter the risks of recession and deflation) had passed. Keeping interest rates too low for too long had two important consequences which came together in such devastating fashion in the global financial crisis."
"First, the extended period of inappropriately low interest rates enticed many American households, whose incomes or previous credit histories would ordinarily have precluded them from becoming home owners, to take out mortgages which they were subsequently unable to service once interest rates eventually began returning to more normal levels. This consequence of abnormally low interest rates was, to be sure, compounded by the way in which sub-prime mortgages were constructed (with artificially low ‘honeymoon’ rates and capitalization of deferred interest payments), but sub-prime mortgages would never have caught on in the way that they did had the general level of interest rates not been so low for so long.
More generally, the extended period of unusually low interest rates also encouraged those who had previously been able to access mortgage finance to take on more debt than would have been possible otherwise, adding to the upward pressure on house prices from those newly enfranchised in the housing market."
"Second, the extended period of unusually low interest rates encouraged investors to take on more risk in order to obtain rates of return that could no longer be provided by relatively low-risk investments. This ‘ferocious search for yield’, as Adair Turner, Chair of the UK Financial Services Authority has described it, prompted a response from the ‘supply side’ of the financial services sector in the form of an ever-growing range of increasingly risky investment products cater to the growing demand for them – products whose risk characteristics neither their creators nor regulators fully comprehended."
"In short, the choices made by central banks in the US and other major advanced economies to keep short-term interest rates too low for too long encouraged both an increased demand for risky investment products and a greater supply of them. One of the reasons (although, again, not the only one) why Australia’s experience of the financial crisis has been less severe than that of most other Western countries is that Australia’s central bank was one of the very few that didn’t make the mistake of leaving interest rates too low for too long in the early years of this decade."
We cannot say it any better than Saul. We do, however, mention that Greenspan’s interest rate policy resulting in (fraudulent) prosperity at home, psychologically mitigated concerns about wars in Iraq and Afghanistan, and the high price of imported crude oil.
GOVERNMENTS AND CENTRAL BANKERS
Australia is relatively blessed in that our central bankers in discharging their obligations to assist the attainment and/ or maintenance of stable prices, balanced and sustainable growth, are independent of government. However, the Head of Treasury, currently Ken Henry, sits on the RBA board and has an input to the decision-making process. It was rather remarkable that the Treasurer, Wayne Swan, has been reported as saying, in parliament, that "fiscal policy has nothing to do with monetary policy". Yet, we know that the overall stimulus package has been increased government spending and borrowings, cash injections from the RBA, and lower (even down to ’emergency’ levels) interest rates.
Ian Macfarlane, ex Governor of the RBA, wrote an excellent book "The Search for Stability", which is exceptionally readable and available in paperback.