Tackling the cost-of-living crisis by increasing it?

May 18, 2022
'Housing bubble' mural by Fintan Magee. Photo: Peter Boyle

The inflation versus wages debate has fired up again following Labor leader Anthony Albanese’s backing of an inflation-matching rise in the minimum wage.

The cost of living crisis is shaping up to be a key factor in the federal election. Working people are hurting from 20-year inflation highs and the Reserve Bank of Australia (RBA) is raising the target cash rate for the first time in a decade.

The RBA doesn’t clarify these somewhat abstract concepts, when it talks about “reducing excess liquidity in the economy” and “redirecting investment streams away from high-risk assets”.

Most of us have a grasp of the terms “inflation”, “cash rate” and “liquidity”. But it is less obvious what the RBA statements mean and how it attempts to fight inflation.

It is important not only to understand the RBA's policies, but the mechanisms and intentions behind them.

Let’s dissect what they mean, how they work and the implications of this monetary tinkering.

We all know what inflation means — things cost more — but what causes inflation?

There are two general types of inflation: demand pull and cost push. The first is when aggregate demand expansion outstrips aggregate supply, and this excess demand causes buyers to bid up prices. It’s when people (or some people) have too much money and are therefore willing to pay more for things, allowing businesses to raise prices.

Cost-push inflation is when the costs of production in the supply side of the market rise and businesses then raise prices to cover costs. In a competitive market, where sellers must take market prices, rising costs will cause producers to reduce production or even leave the market, leading to an undersupply and, again, causing buyers to bid up prices until the market reaches a new equilibrium.

Even though this almost never happens day-to-day — I don’t remember supermarkets ever running out of cheese, nor have I repeatedly bid more for scarce cheese supplies — sellers anticipate this process and do the work of raising prices for us.

What do we do about inflation?

The RBA keeps a very close eye on inflation, its aim being to keep it in the target range of 2–3% a year. When it sees it rising, it tends to step in.

The main mechanism to tackle demand inflation is to raise interest rates. This reduces excess liquidity in the economy, curbs asset price inflation, reduces appetite for risk, reverses the wealth effect and encourages savings.

The theory is that if money costs more, people will spend less of it, taking out fewer loans for purchases, and thereby cooling demand.

When it comes to tackling supply-side cost inflation, particularly when caused by international supply chain issues or external price shocks such as wars, pandemics or oil prices, little can be done to address the causes.

The main response is to treat it as if it was demand inflation; prices go up because of some external factor and are brought back down by pulling money out of the hands of consumers.

In theory, the exchange rate could be manipulated so that imports are cheaper. But the mechanisms to do this are to reduce the supply of Australian dollars in the economy so, in practice, it looks very similar.

In both cases, there is less money around and so money costs more.

What type of inflation do we have now?

According to the government, it is definitely supply-side. Obviously there is a large supply effect; there is a pandemic and several wars are happening. The data also shows that there is not sustained demand inflation.

Despite constant fear-mongering about COVID-19 supports driving inflation, there is little evidence for this. For government spending to raise inflation, one of two things must happen: the Australian dollar must devalue, increasing the price of imports; or the spending must manifest in domestic markets as increased demand.

That means the value of the dollar must fall dramatically, which it has not, or working people having more money and buying more things, which they don’t and haven’t.

Predictably, most of the COVID-19 stimulus went to corporations, subsidising wages or providing businesses with emergency relief funds. Much less was given to those who lost their jobs.

This spending could have entered domestic markets through wage rises. The household spending and aggregate demand have significantly recovered.  People are buying more things, not because they have more money and are willing to pay more for the same goods, but because they previously couldn’t under the pandemic restrictions.

People spending more may look like demand inflation, but it is not due to any sustained rise in income.

We can see this in real wage growth. While wages have returned to pre-pandemic growth rates, they increased at significantly less than inflation.

This is where the technical mechanism of cost inflation — reduced supply — is important. It is a response to pandemic restrictions on consumers and supply chains, despite it appearing as an rise in spending; it’s a recovery from the mandated inability to spend.

Meanwhile, the wealth of the richest people in Australia doubled over the past two years. Some say government overcompensation for pandemic losses has driven up private incomes during the pandemic, but it is vital to look at the recipients of this “overcompensation”.

If the main recipients were JobKeeper businesses, this is not a major contributory factor to demand inflation. Gerry Harvey can only eat so much home brand cheddar.

What does this mean for workers?

The RBA is attempting to deal with supply-side cost inflation, as if it is demand-side, through its main monetary policy mechanism — raising the cash rate target which raises interest rates as money becomes more expensive.

For investors and businesses, the cost of borrowing is higher, so the margin on leveraged investments is lower and their profits may fall. Alternatively, they may go up if inflation outstrips interest rates; inflation is, after all, businesses putting up prices.

What about the workers?

As interest rates go up it means that your borrowings — mortgages, car loans, credit cards — and your cost-of-living goes up as well.

The same goes for people who are exposed to debt in any way, such as those who rent from a landlord with a mortgage. Repayments go up, rent goes up and now you have less money.

This is the devastating one-two punch that most Australians will experience: the rising cost of living through consumer prices and rising costs of debt and housing.

Families will feel the pinch, not as an unfortunate side-effect, but by design.

The RBA’s “cooling aggregate demand” means its needs you to spend less money and the only way it can make this happen is to make sure you have less money.

All the earlier sidebars about inflation mechanisms and buyers bidding up prices are relevant: the RBA’s aim is to make sure buyers are unable to bid up prices, even in the face of supply shortages.

This means choosing between strawberries and blueberries instead of buying both, choosing the cheddar instead of the brie, and not turning on the heater this winter.

By making some portion of the population unwilling, or unable, to enter consumer markets, the RBA hopes this will cause demand to fall to match available supply and that inflation will return to the 2–3% target.

None of this is aimed at reducing prices for struggling people, but at making sure prices rise more slowly.

The professional managerial class, or high-earning dual income families, will not be making sacrifices. Rather, the burden will fall disproportionately on First Nations peoples, single mothers, older women, pensioners, minority communities, the un- and underemployed and the huge number of people working multiple, insecure, minimum-wage jobs.

While the number of dollars they lose may be small, the impact on their lives will be enormous.

If you strip away the economic jargon, they are trying to tackle the cost of living crisis by increasing the cost of living.

What is to be done?

As a short-term solution, wages must rise. If there is little we can do to address the external causes of global supply-side inflation, then we must address the other half of the equation. If we cannot reduce the cost of living to keep parity with wages, we must raise wages to remain in line with costs.

According to Treasury, wage rises up to the value of inflation plus productivity rises do not increase the risk of future inflation. The basic idea is that if wages and inflation grow hand in hand there is no net gain or loss on either side.

Additionally, if productivity rises it increases the supply of goods in the market; this increased supply allows for demand to increase — in the form of higher wages — without putting pressure on inflation.

Albanese understands this, as do the Treasury department and the economics-graduate Prime Minister, which is why the debate over the call for an inflation-matching rise to the minimum wage is cynical at best.

[Matthew Alexander is an economist.]

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