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Inflation and the Economy: Where to from here?

The Australian economy is experiencing unusually high inflation. Consumer prices increased by 6.1% in the second quarter of 2022 relative to the same quarter of 2021. After a decade of inflation stably below 3%, this surge is causing concerns among policymakers and the public alike.  

In fact, inflationary pressures are felt worldwide, often to a larger extent than here in Australia. This suggests that these pressures mainly stem from global factors. Two, in particular, are relevant. First, the disruption of global supply chains, following the COVID pandemic, has caused bottlenecks and shortages of goods and materials. Second, geo-political tensions in Eastern Europe, and elsewhere, have driven up energy prices, hence raising the costs of production of other goods and services.  

Some domestic factors are also at play. Australia has recovered quickly from the COVID recession. Overall growth in Gross Domestic Product (GDP) has been accompanied by a sharp decline in unemployment. These favourable conditions have strengthened domestic demand for goods and services. At the same time, floods earlier in the year have further constrained supply. As a result, the imbalance between supply and demand has worsened, contributing to the price hike. 

Chain reaction
Bumps ahead?

Managing inflation is primarily a task of the Reserve Bank of Australia (RBA). Its mandate is to keep inflation within a target band of 2%-3% in the medium term. To this end, the RBA uses the cash rate as policy tool. In practice, when the inflation rate overshoots the target band, the RBA progressively increases the cash rate. This makes borrowing for investment and/or consumption more costly. As a result, demand for goods and services declines and prices tend to grow less fast. The increase in the cash rate also contributes to anchoring inflation expectations. If people and businesses believe that inflation will continue to increase, then they build this expectation into their behaviour, for instance when renegotiating contracts, and the expectation eventually becomes self-fulfilling. By raising the interest rate, and thus signalling its commitment to inflation stabilisation, the RBA moderates inflation expectations.  

This explains, and justifies, why the RBA has increased the cash rate quite aggressively in the last few months. There is evidence that this intervention is starting to produce some beneficial effect. For one thing, the quarter-on-quarter inflation rate has declined from 2.1% in the first quarter to 1.8% in the second quarter of 2022. So, inflation is still growing, but at a declining speed. For another, market’s long-term inflation expectations remain anchored at the target band. This supports RBA’s current forecast of inflation returning to 3% by end of 2024, after picking at 7.8% by end of 2022 and declining to 4% in 2023.  

However, there could be some significant bumps on the road. The exact adjustment path of inflation over the next two years will depend on the interplay of several factors. Monetary policy cannot fully offset shocks that are global in nature. Therefore, the speed at which inflation will return to target will critically depend on the persistence of supply chain disruptions and geo-political instability. There is some evidence that supply chains are, slowly, being restored, but the geo-political scenario remains very uncertain. Domestic dynamics will also affect the adjustment path. If prices built into multi-year contracts reflect short-term inflation expectations (which are on the rise) rather than long-term ones (which, as noted, are stable around the target band), then inflation inertia could delay adjustment.  

Furthermore, the increase in the cash rate is not without consequences. A higher cash rate helps reduce inflation by weakening demand and hence causing a slow-down in the pace of economic activity. If the economy is overheating, then this is not an issue. But if high inflation is due to shocks that affect the supply-side of the economy, as it is currently the case, then a trade-off between disinflation and economic activity emerges. Bringing inflation down requires an increase in the cash rate, but an increase in the case rate weakens the economy and could lead to a contraction, or even a recession. The typical example of this policy dilemma is the stagflation of the 1970s, when most countries experienced high inflation combined with recessions following the oil price shocks.  

Economic decline
A delicate balancing act

The current scenario might not be as bad as it was back in the 1970s. The Australian labour market is strong. The unemployment rate is down to 3.5%, a record low, and the number of unemployed people has declined by 27.6% in a year. At the same time, GDP is growing at a solid 3.3% on an annual basis. There are however a few red flags, such as the evident decline in consumer’s confidence, housing prices, and business investment indicators. 

Bigger concerns arise from the international landscape, which clearly impacts on Australia’s macroeconomic prospects. In the United States, job data continue to be favourable, but GDP declined in the second quarter of 2022. Furthermore, the yield on 10-year US government bonds is now lower than the yield on 2-year maturities. This yields “inversion” has often been a predictor of recessions in the past. In China, a sharp decline in consumption and continued instability in the property sector have caused a worse than expected slowdown in the second quarter of 2022. In general, the IMF has recently emphasised how the tentative global recovery that started in 2021 is now threatened by some significant downside risks.  

In this context, the challenge for the RBA is to continue its intervention to offset inflation, while keeping the economy on a steady, upward sloping trajectory. This will most likely involve further increases in the cash rate before the end of the year. There is no consensus on how high the cash rate will go, but current predictions range from 2.5% to 3% (and some possibly even higher). In setting the path for future cash rate increases, the RBA will need to monitor wage growth data and housing prices, in addition to global macroeconomic developments. 

A final consideration relates to fiscal policy. Its role, in this phase, is primarily to determine the distribution of the burden associated with the negative shocks that have hit the economy. In this respect, across the board tax cuts tend to benefit disproportionally more those on higher incomes. Supporting those on lower incomes instead requires making use of any available fiscal room to strengthen targeted benefits and sustain public services (i.e. education, health), as inflation erodes existing budgetary provisions for such services.  

Author

Professor Fabrizio Carmignani

Fabrizio Carmignani is a Professor of Economics and Dean (Academic) at Griffith Business School. His research is in the broad field of applied macroeconomics and applied econometrics. His recent publications are in the areas of conflict economics, tourism economics, policy modeling, spatial econometrics, and the economics of natural resources. He was also appointed as a member of the ARC College of Experts from 2019 to 2021.

He is a regular contributor to various media outlets, where he writes and speaks about fiscal and monetary policy issues in Australia and overseas. Between 2002 and 2009 he worked for the United Nations in various roles, including the position of First Economist in the Trade, Finance and Economic Development Division of the UN Economic Commission for Africa. Fabrizio holds a PhD from the University of Glasgow and a Research Doctorate from the Universita’ Cattolica in Milano.

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