HowTo: deal with inflation. Or, petrol prices, fresh-food prices, unemployment and your mortgage

SYDNEY (Thomson Financial) – Job advertisements in newspapers and on the Internet averaged 249,915 per week in June, 0.8 percent fewer than in May but 36.1 percent more than a year earlier, Australia and New Zealand Banking Group Ltd (ANZ) said.

Score. Unemployment in Australia is 4.2%, a 32 or 33 (depending upon where you read it) year record low. Yes, that’s pretty low. More importantly, there’s an argument ‘out there’ that it may find its way below 4% next year. Currently, employment is growing at around 3% per year, while the economy itself grows at about 4%. Wages are growing at around 4.1% per year, only just below the Reserve Bank’s Action Station of 4.5%.

The government is aiming to ease this with attempts to increase labour force participation, currently running at 65% – pretty high. Skilled immigrants, older workers, etc. are being encouraged (I mentioned this in the very formative days of this blog). There isn’t a lot of capacity at all left in the labour supply, and we can depend upon our newspapers for anecdotal evidence about how hard it is to fire hirees.

Macroeconomics 101 with Hubbard and O’Brien

First-year students: what happens when the economy has more-than-full employment? Yes, inflation. Returning to your textbooks:

Inflationary expansion graph

We should be wary, in this post, about cost-push inflation (I’m probably more Keynesian than not, yes). With wages increasing and input prices (thanks to oil/petrol/gasoline) increasing, prices consumers pay have to increase with the costs-of-production. In turn we demand higher wages, and with a squeezed supply of labour we can get them, sending prices higher still. Hence, inflation.

In the graph nicked from the textbook I use, our example economy has expanded beyond potential real GDP (i.e. Full Employment). In the labour market this means more jobs than people (keeping it simple), driving up wages. In the consumer market it means more demand than supply, driving up prices, which drive up wages – do you see the spiral? In fact our economy will not sustain unemployment below the Non-Accelerating Inflation Rate of Unemployment. Thus we end up back at Full Employment in the graph, inexorably, but along the way we’ve picked up positive inflation.

Now to the point. How does the government (broadly speaking) prevent increasing inflation? Contractionary Monetary policy, i.e. increasing interest rates. There is a fundamental equation for the economy – what is called macroeconomic equilibrium:

Aggregate Demand = Consumption + Investment + Government Expenditure + Net Exports

In equilibrium Aggregate Demand = Aggregate Supply (points A and C on the graph). Here we are at point B, where Aggregate Demand > Long-Run Aggregate Supply.

Fortunately Australia’s exchange rate is keeping things a little bit in check (high-valued Australian dollar = declining Net Exports = declining Aggregate Demand, reducing the inequality), but not enough. Governments have two options, (i) change Government Expenditure (increase taxation, reduce spending), but that’s not popular in an election year, and/or (ii) increase interest rates. Higher interest rates means (a) less investment (in houses, in new factories, you name it), and (b) less consumption spending (less access to credit, less household wealth, etc.). Both of these also slow down Aggregate Demand, Employment, and so forth. The problem? Interest rate increases are also unpopular.

Reserve Bank independence

This should not be a problem – central banks are independent in all good economies, and the Reserve Bank of Australia is no different (in that it is independent, but periodically hassled by an unpopular government). According to the SMH, the Reserve may not only increase the borrowing rate above the current 6.25%, but put serious brakes on:

Financial market observers believe there is a good chance the bank will make a pre-emptive strike against inflation next month by raising the cost of borrowing to a decade high of 8.3 per cent.

Cripes. I’d be surprised, but it would no doubt be effective. In both holding inflation down and losing the Liberal party their majority in parliament. Howard used them to win his last election, and has bizarrely made promises that they’ll stay the same for now (like I said, periodically governments interfere with central banks – which alone should cost the bastards their jobs). Given the election has to called by November and held by mid-January, his chances of getting through the election without being burned by interest rates are slim.

Interest rate electioneering

So sensitive are the Liberals to the interest rate issue, in fact, that they’re bully-pulpitting all over the place. The treasurer recently gave one of our networks a talking-to after they discussed the increasing burden, under the Howard government, of household debt. I fail to see how they’re plan of “just don’t think about your debt and the interest you pay on that debt” is going to work. Here is the nature of things:

  • Interest rates have steadily increased.
  • As has debt. In fact, while interest rates are lower than the Bad Old Days to which Team Howard/Costello like to refer, debt is far higher – meaning the debt households carry, and their susceptibility to interest rate increases, is far greater.
  • House prices are far and away greater than they’ve ever been – necessitating higher levels of borrowing. Increase levels of leverage in mortgages has both increased debt and – again – led to further increases in house prices.

With that dynamic we are brought the the final fit, the final bellyache:

  • The economy is running at too rapid a pace: employment is too high for stable economic growth.
  • Costs of production are increasing due to wage demands, as well as increasing petrol prices.
  • Prices of fresh foods in areas hit by drought, flood, you name it (honestly, the weather these days!) are increasing.
  • Inflation, and inflationary pressures, are reaching a point past which they cannot go, for fear that the Reserve Bank will lose the ability to manage them effectively.

And in the middle is John Howard, insisting that he can smudge away half of that stuff if we agree to ignore the other half – while we lose our houses. The short answer for mortgaged-home owners is this: good news on the economy is bad news for you. Your interest rates will go up unless something very bad happens to the economy exogenously, and the Prime Minister and the Treasurer are lying when they pretend that they can control almost any of this.

What we are seeing is a government that mostly sat around and softly guided an economic expansion that was set up before they arrived. While in office we’ve seen financial and commodities booms that have taken their economy and run away with it. Ignore them and listen to actual economists, financial analysts and reserve bankers – that’s the word on the street. And just as I said the other day, remember Christopher Walken’s immortal lines from the Suicide Kings:

That phone call I got, it came from outside high walls and fancy gates; it comes from a place you know about maybe from the movies. But I come from out there, and everybody out there knows, everybody lies: cops lie, newspapers lie, parents lie. The one thing you can count on: word on the street … yeah, that’s solid.

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1 comment so far

  1. shantal on

    i love how this reveal topic and basic information and fucking pussycloth, bloodcloth, rasscloth


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