I remember once asking a central banker why they didn’t just aim to keep prices stable. Why is inflation necessary at all?
The answer was essentially that a little bit of inflation is better than the alternative: of deflation. Deflation – a phenomenon where prices fall over time – is unambiguously bad.
It’s bad for the economy when people delay spending because they think an item will be cheaper if they wait.Credit:Paul Jeffers
When people think prices will be cheaper tomorrow, they will delay making purchases, leading to a widespread “consumer strike” which is bad for the economy.
Far better, then, to err on the side of running things too hot, than too cold.
A little bit of inflation also helps to lubricate the wheels of capitalism in various ways.
Let me explain.
If prices are not rising, it can be very noticeable when a company decides to lift prices for the goods or services they provide. If they face supply disruptions which increase their costs, however, companies may need to lift prices to maintain profitability. The alternative, if they can’t increase prices, could be to lay off workers or otherwise cut their wages bill.
So, an environment OF rising prices can help to provide the cover needed for companies to pass on higher costs to survive.
A bit of inflation can also help companies straining to reduce their wages bill by simply lifting worker wages by less than rising prices – i.e. deliver a real pay cut. That’s not great for workers, but nor is losing their job instead.
For borrowers, inflation can also be beneficial.
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As we’re about to find out on Thursday in the mid-year budget update, the Australian government has accumulated significant debts during COVID.
It’s ok. We’ve done it before. And we’ll no doubt do it again. The answer to high levels of debt, historically, has been to simply let an expanding economy and rising inflation “inflate” away the real value of the debt incurred. That is, we should pursue policy settings which help the economy and prices to grow so fast, that the debt is worth less, in relative terms, tomorrow than it is today.
Mortgage holders also benefit if rising inflation pushes wages higher, reducing the size of their debt relative to their income.
Before COVID, of course, it had become clear workers lacked the degree of bargaining power they once had to push for higher wages, whether due to declining rates of unionisation, the rise of labour-replacing technologies or more competition from cheaper offshore workers.
But during COVID, I have observed a noticeable shift in thinking from our central bank to be even more determined to ensure workers get the pay rises they are due before interest rates are returned to more normal levels.
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As governor Phil Lowe said on Tuesday, future interest rate rises “will require the labour market to be tight enough to generate wages growth that is materially higher than it is currently”. Furthermore: “This is likely to take some time.” Get it?
Our Reserve Bank won’t be lifting official interest rates until it is confident workers are enjoying the sorts of pay rises that would also assist in meeting higher mortgage repayments.
And as we return to life pre-pandemic, that might still be some time away.
You can relax about inflation for now.
