The threats from inflation are real and we can’t be complacent

It’s remarkable how quickly we have become blasé about high inflation. Last week’s week’s announcement saw inflation come in at 7.3 per cent for the 12 months to November 2022; a figure that not so long ago would have alarmed us enormously. Of course, inflation has been a story for a while now, and is merely meeting market expectations, so it’s perhaps not surprising that the news couldn’t knock Prince Harry’s memoirs off the front pages.

In one sense then the news is good – or at least not catastrophically bad: inflation appears to be behaving roughly as predicted by the RBA. No doubt everyone would have preferred inflation to have clearly peaked, especially home owners who are now reading headlines about further rate increases and dreading the next RBA board meeting.

Certainly, there are some indications that inflation has peaked in the United States and the Eurozone, though in both cases it remains well above comfortable levels. Even in the UK, inflation appears to be peaking. However creeping complacency is dangerous. Serious threats remain.

First, inflation is starting to pick up in China as the country slowly opens after its latest COVID lockdown. While it remains low by global standards, high Chinese demand could very easily stoke the inflationary fire, just as it begins to wane slightly. While renewed inflation on its own would be a concern, the big risk from this is that another inflationary spike will feed into global inflation expectations.

There are many different paths to higher inflation. The current global explosion has been driven by supply shortages, war, energy price rises and excessive government stimulus during the pandemic.

These shocks represent a more temporary form of inflation. Inflation from short-term shocks — though concerning and harmful — is easier to get rid of, despite what you may think from recent experience.

It’s when people start to expect inflation to remain at elevated levels that it becomes very difficult to combat. Inflation gets built into wage demands. It effectively becomes self-propelling. There is still a real risk of this happening.

The good news is that inflation expectations fell in December, according to the Melbourne Institute Survey of Consumer Inflationary and Wage Expectations.

It would be a mistake to assume that this means the risk of an inflationary spiral has disappeared. The government has not helped matters in this regard.

While the Treasurer and Finance Minister have both sounded warnings about inflation, the budget remains deep in deficit and their position seems to be that wages should adjust to meet inflation. In effect, they are encouraging inflation expectations. They aren’t doing it for this purpose: they are likely doing it because of concern over the distributional impact high inflation and rising interest has on workers.

But wages are already rising as a result of a very tight labour market. It is simply the wrong approach to further encourage that at this point in time. Moreover, it seems highly unlikely that this strategy will be effective in shielding people from the pain of inflation and interest rate rises — but if it was, the end result would likely be worse, not better.

The wage price spiral of the 70s and 80s was enormously deleterious to Australia. It took a Labor government engineering real wage falls, and a decade of interest rates above 10 per cent, to bring inflation back under control. Not to mention several serious recessions in the meantime.

Growth in living standards in Australia, which had been rising steadily for decades, was quite uneven during this period and it’s not until inflation was under control and the economy was growing again in the mid-90s that we saw a return to the steady improvement of living standards we expect. And Australia probably wasn’t the worst hit. The experience in the UK, in particular, was terrible.

Of course, we have seen several decades where inflation has been benign. Despite a number of predictions to the contrary, the experimental monetary policy undertaken during and following the Global Financial Crisis had little effect on inflation.

Perhaps, like the boy who cried wolf, the inflation hawks have sounded the alarm one too many times. To take a head-in-the-sand approach is to risk serious economic harm, but perhaps the worst thing is that aggressive action to combat inflation may itself cause significant economic harm.

Major economies, like the US, are already at serious risk of sliding into a recession. The rapid tightening of monetary policy may cause almost as many problems as it solves.

Australia is currently in the midst of one of the shortest and most aggressive tightening cycles in the past few decades. Many continue to believe that we will walk the fine line from spiralling inflation back to normality without triggering a recession. This seems highly optimistic.

Some may be comforted by popular predictions that whatever recessions are triggered around the world will be short and less painful than previous ones, but that is at the troops-will-be-home-for-Christmas levels of optimism.

The simple fact is that our complacency about the economy is not at all in keeping with the scope of potential risks we are facing. The fact that policymakers continue to place other priorities above economic stability is equally troubling. Having faced a rough few years, one wonders if we will have another crisis on our hands by this time next year.

Simon Cowan is research director at the Centre for Independent Studies.

Photo by Miraze Dewan