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Why the RBA shouldn’t obsess over inflation when it sets interest rates?

The Reserve Bank Board met earlier today pushing up its cash interest rate for the second consecutive month.

Why?

According to the board’s official minutes, it’s:

“to ensure that inflation in Australia returns to the target over time.”

Some increase in interest rates is justified simply because, with higher inflation, real interest rates are now negative.

But the idea of returning to the old target range does not stand up to scrutiny.

Once the current spike in inflation is over, we need to reconsider both the target range and the whole idea of inflation targeting.

How much inflation are we aiming for now?

The Reserve Bank’s inflation target is consumer price inflation of 2-3%, on average, over time.

Yet for most of the past ten years, that target has been missed, on the downside, as you can see below.

Consumer Price Inflation

But, just recently, consumer price inflation has jumped to 5.1%, and the so-called “trimmed mean” measure of underlying inflation watched closely by the bank has jumped to 3.7%.

Recent inflation is partly a sign of success

While too much inflation can be a problem, it is important to remember that the jump is partly an unintended consequence of success.

Massive public spending offset the impact of COVID and lockdowns on the household outcome and set the stage for a rapid economic recovery.

This spending was necessary but inevitably went to businesses that didn’t need it.

Further, the success of working from home meant many households suffered no reduction in income and were freed of the need to spend as much on travel and clothes, and things such as makeup that go with travelling to work.

As restrictions have eased, households and businesses have been keen to spend some of their accumulated savings, at a time when goods production has been disrupted, especially by the anti-COVID measures in China.

The result has been classic inflation of the kind where “too much money chases too few goods”.

It is very different from Australia’s last major episode of inflation, in the 1960s and 1970s, which was commonly seen as a “wage-price spiral” or “cost-push inflation”.

This isn’t wage-driven inflation

Cost-push inflation was generally seen as arising when powerful unions demanded large wage rises, which were passed on to consumers by corporations with monopoly power.

In the current environment, while monopoly power is still a problem, unions are a shadow of their former selves, with little power to extract out-sized increases.

The result is that wages, as measured by the Bureau of Statistics wage price index, grew by only 2.4% in the year to March, well behind inflation of 5.1%.

This has continued a long downward trend in the wage share of national income.

Wages Share Of National Income

Despite the obvious absence of a wage push, many commentators are still working on the wage-price spiral model, and arguing against allowing wages to rise in line with inflation.

Such a policy would not only be unfair, but it would also be economically disastrous – similar to the austerity policies introduced in many countries in the wake of the global financial crisis, and earlier, when Britain returned to the gold standard in the wake of World War I, helping precipitate and deepen the great depression.

Wages

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