Economics Analysis

Reserve Bank ignorant to truth behind Australia's inflation

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Rate rises have led to protests outside the Reserve Bank building (Screenshot via YouTube)

The Reserve Bank is blaming our soaring inflation on wage pressure, whereas economists argue the real reason is excess corporate profits. Dr Evan Jones reports.

IN LATE FEBRUARY 2023, Jim Stanford, director of the Centre for Future Work (within the Australia Institute), published a study on the evolution of factor incomes in Australia since December 2019. Stanford published a summary here.

During this latter period, corporate profits arising from discretionary price markups have surged, far greater than can be associated with real economic growth and not a product of productivity rises. Thus, Stanford claims, ‘inflation in Australia since the pandemic reflects a profit-price dynamic’, rather than a wage-price dynamic. Stanford notes that the Reserve Bank of Australia’s (RBA) February 2023 Statement on Monetary Policy mentions wages 75 times and profits once.

The RBA responded by claiming that significant price increases were confined to the resources sector, whose prices are determined by impersonal forces (“supply and demand”) in global markets. Nothing to see here, as this huge presence in the Australian economy is apparently outside the authorities’ concern or control.

Except it has been a conscious policy decision to not implement a national domestic gas reservation policy that would have restrained prices. Western Australia has had a formal gas reservation policy since 2006, recently ardently defended by ex-Premier Colin Barnett.

And how are cash rate hikes going to counter this externally-driven surge in energy prices? More, there was no acknowledgement that this presumed causal factor didn’t fit well with the RBA’s preoccupation with so-called wage pressure (of which more later).

The reaction then turned rather hysterical. Mainstream economists dripped condescension towards Stanford. The Australian Financial Review clamoured for apologies and a retraction from the Australia Institute. The loquacious omnipresent Dr Binoy Kampmark has put in a good word for Stanford’s work, at the same time appropriately skewering RBA Governor Philip Lowe’s personality deficiencies.

The Australia Institute responded to critics in April. Yes, it noted, the resources sector was the primary source of current inflationary pressures in Australia — not merely direct but also indirect as downstream producers increase prices in response to higher resource input costs. More, there have been above-cost markups elsewhere in the economy, ignored by the RBA.

Additional confirmatory evidence for the non-establishment Australia Institute’s claims comes from a curious source. On 9 June 2023, in the establishment Australian Financial Review, a wordy advertisement appeared from a mob called ASR Wealth.

ASR Wealth advises that the obvious place for our hard-earned is in companies with pricing markup power:

Adjusting investment strategies to mitigate the risks of inflation means that investors need to find companies that can extract pricing power  – the ability to offset higher costs by increasing prices to within the tolerance levels of consumers – from their businesses.

 

According to [Tim] Montague-Jones [head of Australian equity research at ASR Wealth], investors need to look for companies that have “low-elasticity”, namely companies that create essential products – such as food or utilities – that consumers need and are prepared to pay more for.

 

A case in point was Woolworths, which during the February reporting season (which includes the previous six months up to December [2022]) proved that it had the pricing power it claimed by lifting its revenues and its earnings.

Automatons, with attitude

The reality is that Lowe, programmed, prefers not to know about corporate pricing power. Yet he is an automaton with attitude. He advises that sufferers should take a flatmate or move back in with their parents. Now he wants the battlers to spend less and get a second job.

There is disdain for the suffering he is causing. Lowe claims that the RBA is ‘monitoring closely’ mortgage arrears, which ‘remain very low, although they have increased a little of late’. However, the RBA isn’t accurately monitoring mortgage (or rental) stress. Lowe remains unrepentant.

Meanwhile, the latest CoreLogic property report indicates that loss-making property sales are booming, with all the trauma that involves, especially in east-coast capital cities. Sydney Morning Herald journalist Elizabeth Knight (normally confined to banal business reportage) provides further analysis, highlighting that things are only going to get worse.

I am reminded of an earlier period of relevance. Deputy Governor M J Phillips gave a talk to a business group in May 1990 (RBA Bulletin, August 1990; not digitalised).

Phillips claimed:

“I am not proposing (nor have I ever proposed) the kind of scorched earth approach which would seek simply to grind down the economy until inflation is wrung out of the system. Particularly if the major weapon used were monetary policy, that could produce social problems on a par with those caused by inflation.”

Quite. But there was no sense of irony that the economy was then entrenched in “the recession we had to have”, delivered by a mile-high cash rate in the late 1980s. The costs of that induced recession have never been adequately documented.

Yet the RBA pulled the same stunt some years after. Treasurer Paul Keating gained ascendancy over Prime Minister Bob Hawke and became Prime Minister in December 1991. Keating had installed Bernie Fraser (Treasury Secretary from September 1984) as RBA Governor in September 1989, no doubt hoping for a simpatico official at the RBA’s helm. Fraser didn’t return the favour.

Fraser raised the cash rate from 4.75% to 7.50% in three tranches in August, October and December 1994. It is true that aggregate demand was increasing during 1994. But the scale and speed of the increases were inappropriate as the economy was still recovering from the recession and the Government committed to reducing the budget deficits.

Did Fraser have any idea? Keating believed (as do I) that those rises were a contributing factor to Labor losing the March 1996 Election. In May 2022, Fraser opined that the RBA should go in hard on rate rises. He hasn’t learnt anything.

It’s the same elsewhere. Stanford’s 2022 report (as above) on the state of the Canadian economy highlights the Canadian central bank’s pig-headed response to inflation. The report is aptly named ‘A Cure Worse than the Disease?’ There are direct parallels between the Bank of Canada and the RBA in its mentality and its actions. The similarity reflects a common group-think of central bankers everywhere.

Blinkered central bankers are generating crisis in the UK. The Bank of England, rather than reflecting on its dogmatic stance, is pressuring UK banks to go easy on its stressed home mortgagors — shifting elsewhere its own responsibility for the crisis. The same goes for New Zealand. The European Central Bank, presided over by Christine Lagarde, another automaton (my French correspondent calls her “a sock puppet”), has recently raised rates to a 22-year high.

At the risk of mixing metaphors, it is as if these central bankers are hellbent on only looking for their lost keys under the lamppost.

The central bankers refuse en masse to investigate closely how economies function as a basis for a more hydra-headed and nuanced response to inflation. Why not pursue the key supply chains heralding substantial price rises through to the origins of the pricing pressure?

Conventional wisdom(s) and contrary opinion

What mechanism does the RBA imagine that will successfully bring inflation down? During the 1960s, it is my understanding (the documentation is surprisingly poor, in spite of voluminous academic and official literature) that the dominant indicator of the state of the economy and objective was the state of “aggregate demand”.

Now here is a conundrum. In 1958, engineer-turned-economist A W Phillips published an article (using British data) claiming a long-term inverse empirical relationship between the level of unemployment and the rate of wage growth. The relationship was soon converted to an unemployment-inflation trade-off which became generally known as the Phillips Curve. Whereas the Curve was an empirical estimate with no causal implications, the implicit story was that behind inflation was a tight labour market wages costs push.

A substantial academic debate took place about the legitimacy of the Curve and the presumed stability of the unemployment-inflation relation. Contemporary economists were wary of its so-called stability, its over-simplicity in terms of explaining contemporary inflation, and thus its utility for understanding and for policy. In Australia, critics highlighted the Australia-specific role of the Arbitration Commission in wage determination and the role of the shifting terms of trade in influencing inflation.

Purist U.S. economist Milton Friedman (and fellow travellers) claimed that there was no relationship at all. There is a level of unemployment, initially termed “the natural rate”, below which an inflationary tendency will set off. Inflation, however, could go to any level, internally fuelled by economic agents building in “inflationary expectations”.

Friedman received the Nobel Memorial Prize in Economics Sciences in 1976. In his acceptance speech, titled ‘Inflation and Unemployment’, Friedman makes two key claims. One, that the Phillips Curve relation “was adopted by the economics profession with alacrity”. Two, “it seemed to provide a reliable tool for economic policy”, akin to “the policies adopted by almost every Western government throughout the postwar period”.

Friedman is dramatically wrong on the first count. On the second, he misrepresents the halting indecision and pragmatism of the so-called purely stabilisation-oriented macroeconomic policies during the post-war period.

For Friedman, the ultimate source of inflation was simply the increase in the money stock, which facilitated the realisation of inflationary expectations. During the 1970s, the idea, labelled monetarism (built on the historic quantity theory of money), found increasing favour in academia and some personnel in finance bureaucracies and central banks.

Moreover, Australia was experiencing raging inflation to the mid-1970s (cynically appropriated for the monetarist cause). Thus did the incoming Fraser Government formally adopt monetarist tenets into policy in 1976, aiming to bring down inflation simply by controlling the money supply growth.

The policy didn’t work, partly because strict control of money supply growth is impossible. Moreover, the then policy priority was wage control, to push back what was labelled “wages overhang”. Monetarist policy, centred on money supply control, was quietly abandoned in 1982, just before the Hawke Government took office in March 1983. The floating of the Australian dollar in December 1983 nailed the coffin further shut. There was no public obituary for monetarism.

The new Labor Government moved to centre an anti-inflation strategy on incomes policy — thus was created the series of accords, with formal self-regulation of wages push in return for maintenance of the “social wage”.

By the late 1980s, the RBA had moved to a view that wage growth was the essential source of inflation. Friedman’s “natural rate of unemployment” was rebranded as the Non-Accelerating Inflation Rate of Unemployment (NAIRU). NAIRU was in effect a pragmatic amalgam of the questionable Phillips Curve and a discredited monetarism, with no theoretical underpinnings.

However, the implications are clear — wage pressure from a tight labour market is the source of inflation. Thus, from May 2022, the RBA proceeded to raise the cash rate as if wage growth was driving this unpredicted inflation.

Except that it wasn’t, as noted above, regarding the work by Jim Stanford and the Australia Institute team.

Lowe’s Morgan Stanley presentation (7 June) mentions problems of food costs, but the RBA hasn’t deigned to forensically pursue the problematic inflation-contributing spheres to their source. It hasn’t even bothered to look at the Coles/Woolworths retail duopoly which has been getting media attention.

The duopoly attracts loyal customers because the latter assume they are getting competitive prices. Noted economist Professor John Quiggin has recently highlighted, in the Australian Guardian, that the two companies have leveraged the conditions to increase their markups over and above rising supply costs.

Lowe’s Morgan Stanley presentation also makes no mention of corporate profits and pricing markups or the public spat with Stanford and the Australia Institute. This telling silence highlights that the speech consciously carries ideological and political undertones.

The contribution of profit pricing markups to current inflation has gained greater exposure in the U.S., thanks to one academic economist in particular — Isabella Weber, in league with her collaborators. I recount the U.S. story at Counterpunch here.

France is in a comparable situation, with the figures even worse. In 2021, dominant European glass bottler and container maker Verallia hiked its prices higher than its rising production costs, hitting winemakers amongst others. Verallia publicised, in self-congratulation, its exploding profits. Pernod Ricard, for example, facing higher costs, raised its prices even higher than its rising costs. So did Pepsi and Nestlé. Leading corporate hypermarket retailer Carrefour, in turn, raised its prices above its supply cost rises.

Pharmaceutical prices were raised with no cost excuses at all (this detail from the weekly Le Canard Enchaîné, 3 May 2023, no digitalisation). Figures published by France’s National Institute of Statistics and Economic Studies (Insee) highlight that regularly purchased goods (including food) increased in price on average by 14% in the year to May 2023.

Read part one of this story here: Reserve Bank has gone mad
Read part three of this story here: RBA's heavy-duty rate rises a lethal tactic in class warfare

Dr Evan Jones is a political economist and former academic.

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