My Reading and Thinking This Week 30 October 2022

 

Inflation Primer
by Greg Jericho

This, along with the BIS annual report below are must read for business executive and strategists. 

Last week at a business conference for the industry I work in, I heard a stock market analyst describe the Reserve Bank of Australia policy of interest rate increases to stop inflation.  It was remarked that interest rate increases would produce higher unemployment which would address the labour shortage we have seen in our industry.  Every time Philip Lowe lectures business and workers on the perils of wage growth, I ask myself, "Why does he keep saying that?"

He does this because the BIS low inflation regime was knocked off balance.  Government power grabbing during Covid is positively correlated to business profit taking in the reopening period.  Working families have paid the price on both counts.  

I began tying the clues together while sitting up in Noosa listening to the very good analysis.    

Having just led the operations and sales of a substantial company through a pandemic event which was very likely far overblown by power and profit takers, I have been focusing my reading and thinking on RBA policy and the pain it is causing hard working families in Australia. I need to understand RBA policy as a business leader and academic.  Many articles I am reading this week are the root causes of the current economic situation in Australia (and America).  They have nothing to do with the narrative I have been seeing in the business press and trade association economic outlooks.  We need to exit the echo chamber and think afresh.   

Greg Jericho says:

There is no evidence at all that a tight labour market, rising wages, or labour costs more generally have anything to do with the surge in inflation since the COVID pandemic. To the contrary, the evidence is clear that wages have had a dampening impact on inflation in this period. Recent inflation is clearly associated with a further expansion of business profits in Australia, to their highest share ever. Attacking inflation by aiming deliberately to increase unemployment and restrain wage growth even further, is a “blame-the-victim” policy that will only make workers pay even more for a problem they clearly did not create.

The current surge of inflation reflects a “perfect storm” of unique factors (mostly global in nature) sparked by the COVID pandemic: which has been, after all, the most dramatic and painful event in the world economy since WWII. It should hardly be surprising that after-shocks from those events will be felt for some time, and the surge in global inflation is clearly one of them. Responding to this unique and unprecedented challenge by simply reciting a monetary playbook formulated in a fundamentally different era (the inflation of the 1970s) is not just inappropriate. It will, if pursued, lead to a painful and unnecessary global recession that will almost certainly engulf Australia, too.

For all these reasons, the Reserve Bank and the Commonwealth government need to take a more careful, balanced look at the nature, causes, and consequences of the upsurge in inflation since the pandemic, before leaping to conclusions that are unjustified – and imposing policy responses that do more harm than good.

Bank for International Settlements Annual Report

Read what the central bank to the world's central banks has to say about inflation.  It is not the narrative the business media is peddling.  The BIS, writing from the central bankers point of view, clearly prefers a situation that is more manageable, in other words a low-inflation regime in which labour (along with other price-setters) is disempowered. 

A low-inflation regime has significant self-stabilising properties. What is measured as inflation is, in large part, the reflection of relative or sector-specific price changes that tend to have a transitory impact on the inflation level. In such an environment, inflation has little effect on the wage and price formation as it loses significance as a factor influencing behaviour. Central bank credibility is instrumental in hardwiring the regime and increasing its robustness.

High-inflation regimes do not have such self-stabilising properties. Inflation becomes a focal point for agents’ behaviour and wage-price formation becomes more sensitive to relative price shocks. Higher inflation, in turn, induces changes in more structural features of wage formation, such as indexation and centralised wage bargaining, which help entrench the regime. It also undermines central bank credibility, further unmooring the inflation process. The experience with the oil price shocks of the 1970s illustrates the mechanisms at work.

Because of the sensitivity of agents’ behaviour to the level of inflation, transitions are self-reinforcing and hence challenging. They are challenging for the models typically used to explain and forecast inflation, which are ill-suited to capturing such behavioural changes. And they are especially challenging for policymakers, because of endemic uncertainty and the possibility of tipping points.

The under the hood perspective sheds light on how monetary policy can best secure a low-inflation regime. The perspective underscores the importance of navigating the transitions and the associated difficulties. Transitioning back from a high-inflation regime can be very costly once it becomes entrenched. All this puts a premium on a timely and firm response. Central banks fully understand that the long-term benefits far outweigh any short-term costs. And that credibility is too precious an asset to be put at risk. 

The highlighted portion explains the actions of the Reserve Bank of Australia.  I recommend that business leaders should start with the big economic picture to interpret their industry and local situation.  This means start with the BIS view above.  Next, you can work your way down to your country reserve bank monetary policy.  Then, understand geopolitical and government fiscal policy.  Commercial banking is driven by monetary and fiscal policy.  Businesses that understand their position through the lens of all these economic drivers will be best situated to devise the right strategies to chart their course.  This is how a true external SWOT analysis works, finally ending up with understanding your local competitors.  If they do not understand the larger economic forces at work, their strategies will not be as profitable as those that do. 

There are some real head fakes going on right now.  Page 77 is a do not miss chart!  

Under the Hood of the Power Dynamics of Inflation 
by Adam Tooze. 

This article ties together BIS views to reserve banking messaging. This is where to learn about the low inflation regime objectives.  Bankers have discouraged wage growth to keep inflation managed since 1993. The decrease of worker collective bargaining power is well known.  Inflation rising causes collective bargaining resurgence. 

As the money supply was astronomically increased during Covid, we saw inflation begin.  Price setters (corporate capital) started raising prices because consumers had money to spend.  Now, the RBA is concerned workers will want wage increases knowing they are paying more for gods and services, and their employers are making larger profits.  What we have right now is a first round price shock.  The central financial and social planners do not want a second-round reaction.  This will lead to companies further raising prices.