Wages can be a great threat to taming inflation

Reports this week that inflation has again increased to 6.8% for the year to April 2023 are grim reading for many. Although the market had not expected inflation to fall again after last month’s data, with unemployment beginning to rise and consumer spending falling, there was some thought conditions might be softening.

Of course there is always some volatility inherent in the monthly figures, and it would be a mistake to over-react to one month’s data. Moreover, there are also lags in the effect of monetary policy. The full weight of previous interest rate increases is yet to be felt. Perhaps inflation is already bending towards the RBA’s target.

However inflation has remained stubbornly high across the world for coming up on two years now. Australia was a late mover in increasing interest rates and our first rate rise in this cycle was more than 12 months ago.

Every time the RBA increases interest rates, the likelihood that it will drive the economy into recession in order to tame inflation also increases. Understanding how this works is key to understanding the risks we are facing.

At the risk of oversimplifying a very complicated relationship, inflation is evidence of a mismatch between aggregate demand and aggregate supply — specifically too much demand and/or too little supply.

In this instance, there were supply blockages and other issues caused by the pandemic and the war in the Ukraine that contributed to our mismatch early on. However, by now it is abundantly clear, despite some confused claims about excessive profit-taking or other factors, excessive stimulation at the tail end of the pandemic is a big driver of our current inflationary episode.

Rising interest rates aim to reduce inflation by curbing the overall level of demand in the economy. The problem is that interest rates are a relatively blunt tool, with significant and variable lags. When you add in the fact that most economic data is backward looking, the risk is that the RBA will be applying the brakes to demand at a point where demand is already falling.

Because prices can rise far easier than they can fall, a mismatch with too much supply and too little demand is usually resolved by a fall in production and an increase in unemployment. This is a recession.

The RBA has been aggressively applying the brakes to demand for more than a year now. The indicators appear to show this has not been enough to tame inflation. Not only has inflation remained far above the desired band but unemployment remains below the natural rate, wages are starting to grow faster and, until recently, consumption remained very strong.

But we are in the midst of the sharpest and fastest increases in interest rates in the past 30 years. It would be a mistake to assume this will ultimately prove to be ineffective: if excessive stimulus can generate excess inflation, then excessive tightening can surely tank demand.

Many hold the view — probably buttressed by decades of benign economic conditions — that the government and the RBA will be able to manage the path of demand with sufficient skill to avoid recession.

While possible, this view seems somewhat naïve. As former president of the New York Fed said of a similar challenge facing the Federal Reserve in America: “the chances of pulling this off are very, very low because they have to push up the unemployment rate. In the past, when you’ve pushed up the unemployment rate, you’ve almost never been able to avoid a full-fledged recession.”

The alternative seems to be allowing inflation to remain above the band for longer, hopefully gradually settling back into the 2% to 3% band the RBA targets; but this comes with other, equally grave risks.

One is the risk of the RBA losing control of inflation expectations. The biggest threat to getting inflation under control and keeping it there in the longer term is higher inflation expectations being built into wages.

Once workers start factoring higher inflation into their wage demands, this creates a self-perpetuating cycle of future inflation that has proven very hard to break — as we saw in the 1970s and early 80s.

The current cycle of inflation was not caused by wages, but that doesn’t mean inflation feeding into wages couldn’t sustain this inflation episode indefinitely. If workers believe inflation will remain above 4% for years, why would they bargain for wages as if inflation was 2%?

Worse still, the government appears to be actively facilitating this process; arguing that many workers should be fully compensated for inflation, whatever the level is.

It would also be a mistake to assume we can simply re-baseline inflation at a higher level. For one, each inflationary episode would shift the baseline higher, ultimately leading to a far deeper recession.

But remember, the impact of inflation is unequal, and often falls heaviest on those who can afford it least. Inflation drives the regressive stealth tax of bracket creep.

Inflation also eats away at the value of savings, especially when compared to asset prices that tend to rise with inflation.

So, for example, if you are saving for a home you are seeing the value of your savings eaten away, while your expenses are rising rapidly and your salary is unlikely to keep up. The problem is worse for those on a fixed income, such as retirees relying on superannuation savings to supplement the age pension.

Inflation also has a disparate effect on businesses and industries. Not all prices rise evenly. Inflation also affects business costs, especially wages. Some businesses fare far better than others in an inflationary environment, because prices for their goods and services rise as fast as costs. But for others, inflation can squeeze or eliminate the viability of their businesses.

Although the cost of living pressures facing households at the moment are quite challenging, in many respects, we may be in the relative calm before the economic storm. It’s easy to see how things could get far worse before they get better.

Simon Cowan is Research Director at the Centre for Independent Studies.