Have you noticed how, at the same time every year, some important prices in our economy are adjusted higher?
It happened in the March quarter.
Schools and childcare centres hiked their fees. Doctors and other health care providers adjusted their fees higher. The prices of subsidised medicines were lifted in line with the consumer price index (CPI).
It means everyone else will spend the rest of the year playing catch-up.
During wage negotiations with employers, people will point to those price increases and say: “Look, the prices of those essentials have gone up again, we need a similar pay increase to keep up with them.”
Then the cycle will repeat next year.
But what would happen to that cycle if some of those important prices were only permitted to increase by a smaller amount each year?
And would a policy change like that help to lessen the damage from future inflationary shocks?
Can we make the economy less inflation prone?
Brian Redican is the chief economist of NSW Treasury Corporation (T-Corp), the central borrowing authority of the state of New South Wales.
Prior to joining T-Corp in 2014, he worked at Macquarie Bank for 14 years, leading the bank’s Australian and New Zealand economic research.
He’s also a former Reserve Bank economist.
Mr Redican has decided to wade into the debate about the way in which certain prices are set in our economy and what policymakers can do about them.
He says if we want to make Australia’s economy less inflation prone in the future, we really need to think about how inflationary shocks work their way through the system.
We also have to accept that central banks don’t have as much control over inflation as some people imagine.
“Not only is it a waste of time arguing over the minutiae of monetary policy movements, an unrealistic belief in the omnipotence of central banks leads to misguided policy recommendations that do more harm than good,” he said.
“Moreover, these arid debates distract attention away from more productive discussions about policy changes that could make the economy less inflation prone in the long term.”
Mr Redican shared these written thoughts with the ABC last week.
He said it was well understood how soaring energy prices, supply-chain disruptions and cashed-up consumers combined to deliver the perfect inflationary storm in recent years.
Inflation soared into the high-single digits around the world and almost reached 8 per cent in Australia.
Inflation has fallen sharply since then, but it’s still above 3 per cent, and it’s informing the debate about whether the Reserve Bank of Australia (RBA) has tightened policy enough.
“This is why it is important to understand the limits of what central banks can do,” Mr Redican said.
The ‘impulse’ and ‘propagation’ stages of an inflation shock
What can central banks honestly do with inflationary shocks?
“When oil prices double, it directly injects an inflationary impulse into the economy as petrol and diesel prices rise sharply. Then, this price shock works its way through the economy as every firm that uses petrol or diesel — which is most — responds to the jump in input costs,” he said.
“Obviously, the RBA cannot do anything about surging oil prices.
“The best they can hope to do is limit the extent to which firms pass on those higher costs by keeping inflation expectations anchored. That is, while they can influence inflation, they cannot control it at all times, which is why the RBA has highlighted the advantages of ‘flexible’ inflation targets.”
The other consideration is the way an inflationary shock is propagated through the economy, and the mechanisms that amplify or dampen the initial impulse, he said.
“For example, tax excise rates on tobacco and alcohol are indexed to inflation. This means that there is an additional increase in consumer prices when the indexation takes place,” he said.
“And, again, the RBA cannot do anything to prevent this.
“Similarly, in 2023 the Fair Work Commission gave a very large increase to the minimum wage and award workers to ensure that real wages did not fall.
“This is another mechanism that amplifies an initial inflationary shock as firms pass on those higher costs. It also takes time for these effects to materialise as some organisations — such as schools — have to wait for the new calendar year before they can change prices,” he said.
It would be ‘impractical’ to crush the economy to stifle inflation
Now, Mr Redican says, even though central banks can’t precisely control inflation, we can still hold them accountable for ensuring that the pre-conditions for low inflation remain in place.
He said if those “pre-conditions” are maintained, people are likely to keep believing that inflation will return to the RBA’s target range and wages will grow at a pace that’s consistent with sustained low inflation.
“Even with the large increase in the minimum wage last year, this remains the case in Australia,” he said, encouragingly.
“And while that is so, it makes sense for the RBA to display patience as the previous inflationary impulses eventually fade.”
He also said that while people arguing that the RBA should do more to fight inflation might concede that the bank is powerless to prevent surging oil prices or supply-chain disruptions, it’s unrealistic for them to argue that the RBA could be making room for those unavoidable price rises by crushing the economy to ensure that other prices fall.
“This is theoretically possible but impractical in the real world,” he argued.
“The deflationary impact of very tight policy would appear just as the initial inflationary impulse was receding.
“Rather than smoothing inflation it would make it more volatile; the exact opposite of effective counter-cyclical policy,” he said.
At any rate, Mr Redican says thinking about inflation this way — as a series of impulses that either get amplified or dampened as they make their way through the economy — provides a more nuanced view of what central banks can and can’t do to influence the path of inflation.
“It also highlights something very practical that governments could do to help keep inflation low, which is to ensure that inflation propagation mechanisms dampen, rather than amplify, inflationary impulses,” he said.
“In this regard, Westpac’s chief economist, Luci Ellis, argues that excise rates, for example, should be indexed to 2.5 per cent rather than the actual inflation rate.
“Along similar lines, why not increase the minimum wage by 3 or 3.5 per cent every year rather than deliver large increases when inflation is high and small wage increases when inflation is low?
“More stable energy prices are another area that would make Australia less inflation prone.
“Focusing on these issues is more helpful in ensuring that Australia remains a low-inflation country, rather than wishfully thinking that our inflation problems would have disappeared if only the RBA had lifted rates another 25 or 50 basis points,” he said.
What did Luci Ellis say?
Mr Redican’s reference to Luci Ellis was noteworthy.
Dr Ellis famously left the Reserve Bank last year to take up her senior role with Westpac, and she seems to be enjoying the relative freedom of expression it’s afforded her.
Last month, she wrote a very interesting article along similar lines, in which she suggested that many important prices in the economy should be indexed differently.
“If Australia and the world are indeed facing a more inflationary environment — or as the RBA Governor put it, ‘shock after shock after shock’ — surely it would make sense to refine the economic policy architecture to be more resistant to inflationary surges,” she wrote.
“One obvious improvement would be to stop indexing administered prices such as education fees and subsidised medicines to the consumer price index (CPI). This simply propagates a surge in inflation into the following year.
“Indexing by 2.5 per cent, the midpoint of the RBA’s inflation target, would avoid this issue.
“Another refinement that would improve the response to inflation surges would be to index tax brackets by 2.5 per cent, as we have previously advocated.
“Indexing by 2.5 per cent would be preferable to CPI indexation in a range of other domains, too.
“Governments and others could build a preference for contract bids with escalation clauses fixed at 2.5 per cent annually, not CPI-linked indexation clauses.
“Capital gains could be taxed at the full marginal rate on a ‘real’ return using a 2.5 per cent annual inflation rate. This would remove the tax preference for capital gains over rental income — a significant distortion in the housing market — without the complexity of the pre-1999 system and without having to touch negative gearing.
“And all of these policy refinements would help anchor inflation expectations by keeping that 2.5 per cent figure front of mind,” she said.
And she signed off with this comment.
“Achieving a soft landing after a large shock cannot be left to one policy tool that operates unevenly across the community and is not well tuned to all kinds of shock,” she said.
Dr Ellis worked at the Reserve Bank for 32 years, in case you were wondering.
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