Demystifying Inflation, Interest Rates, and the Cost-of-Living Crisis

(Originally published 18 May 2022 in Green Left, Issue 1346)

The inflation vs wages debate has fired up again in recent days following opposition leader Anthony Albanese’s backing of an inflation-matching increase in the minimum wage. The cost of living crisis is, unsurprisingly, shaping up to be one of the key factors in deciding the next leader of the country; both here in Australia and in just about every country around the world, from France to Sri Lanka to the Philippines. Working people are hurting from 20-year inflation highs, and in response the Reserve Bank of Australia (RBA) is raising the target cash rate for the first time in a decade.

These concepts and their interactions are somewhat abstract, and the RBA doesn’t necessarily clarify things with their statements about reducing excess liquidity in the economy and redirecting investment streams away from high-risk assets. Most of us have a fairly concrete grasp of what the terms — inflation, cash rate, liquidity — refer to, but it is less obvious what exactly these statements mean in practice and how they attempt to fight inflation.

It is important not only to understand what these policies are saying, but also the mechanisms and intentions behind them. In an attempt to demystify some of the jargon, let’s dissect in slightly more detail what they mean, how they work, and what the implications of these arcane monetary tinkerings actually mean for the people who make up Australia’s economy.

Let’s get a little bit of economic theory out of the way, starting with inflation. We all know what it means on some macro-level — things cost more now — but what causes it? Broadly speaking, economists say there are two types of inflation: demand pull and cost push. These are very general definitions, but they will do for our purposes. Demand pull inflation is when aggregate demand expansion outstrips aggregate supply and this excess demand causes buyers to bid up prices. In less jargonistic terms, it is when people have too much money and are therefore willing to pay more for things, allowing businesses to raise prices.

Cost push inflation is when the costs of production in the supply side of the market increase and businesses must raise prices to cover costs. To be properly technical, in a competitive market where sellers must take market prices, rising costs will cause producers to reduce production or even leave the market, leading to an undersupply and again causing buyers to bid up prices until the market reaches a new equilibrium.

Even though this technical process is almost never what happens with day to day items — I don’t remember the supermarkets running out of cheese, and then personally iteratively bidding more for scarce cheese supplies; at best we can say that sellers anticipate this process and do the work of raising prices for us — there is a point to laying out this theoretical stuff, which we will get to later.

What do we do about inflation?

The RBA keeps a very close eye on inflation, with their aim being to keep it in the target range of 2 to 3% a year. When they see it rising, they tend to step in. The main mechanism to tackle demand inflation is to increase interest rates. This reduces excess liquidity in the economy, curbs asset price inflation, reduces appetite for risk, reverses the wealth effect, and encourages savings. Basically, the theory is that if money costs more, people will spend less of it, taking out fewer loans for consumer purchases and cooling demand.

When it comes to tackling supply-side cost inflation, particularly when it is caused by international supply chain issues or external price shocks — such as wars, pandemics, or oil prices — there is very little they can do to address the causes. The main response is to treat it as if it was demand inflation; prices go up because of some external factor, and are brought back down by pulling money out of the hands of consumers. In theory, the exchange rate could be manipulated so that imports are cheaper for Australians, but the mechanisms to do this are to reduce the supply of Australian dollars in the economy, so in practice it looks very similar. In both cases, there is less money around and so money costs more.

What type of inflation do we have now?

According to the government, definitely supply-side. Obviously there is a large supply effect; there is a pandemic and several wars are happening. It is also, when you look at the data, equally obvious that there is not sustained demand inflation. Despite constant fear-mongering about COVID handouts driving inflation, there is little evidence for this. For government spending to increase inflation, one of two things must happen: the Australian dollar must devalue, increasing the price of imports; or the spending must manifest in domestic markets as increased demand. That means the value of the dollar falling dramatically, which it has not, or working people having more money and buying more things.

Predictably for a LNP government, most of the COVID stimulus has gone into the hands of business owners, subsidising wages or providing businesses with emergency relief funds, while a much lesser amount was given to those who lost their jobs. For all the trickle-down theorists out there, this spending could have entered domestic markets through wage increases, which have not eventuated. The data bear this out. While household spending and aggregate demand has significantly recovered as pandemic restrictions have eased, the key here for demand inflation is that people are buying more things because they previously couldn’t, not that people have more money and are willing to pay more for the same goods. This may look like demand inflation, as people are spending more, but it is not due to a sustained increase in income. We can see this in real wage growth; while wages returned to pre-pandemic growth rates, they increased at significantly less than inflation. This is where the technical mechanism of cost inflation — reduced supply — is important to understand; this is a response to pandemic restrictions on consumers and supply chains despite its manifestation as increased consumer spending; a recovery from the mandated inability to spend.

What did happen was that the wealth of the richest people in Australia doubled over the past two years. Commentators have made arguments that government overcompensation for pandemic losses have driven up private incomes during the pandemic, but it is vital to look at the recipients of this overcompensation. If the main recipients of ‘overcompensation’ were Jobkeeper businesses, then this is not a major contributory factor to this demand inflation. Gerry Harvey can only eat so much home brand cheddar.

What does this mean for everyday Australians?

So we have supply-side cost inflation, and the RBA attempts to deal with it as if it is demand-side through their main monetary policy mechanism, increasing their cash rate target. The specifics of how they increase the cash rate are not important here; the outcome is that interest rates go up and money becomes more expensive.

For investors and businesses, this means that their profits may fall; the cost of borrowing is higher, so the margin on leveraged investments is lower. On the other hand, they may go up if inflation outstrips interest rates — inflation is, after all, businesses putting up prices. If increased prices lead to increased revenue and profits, well, hunky dory. Investments have no cost of living. Sure, they have increased operating costs, but these are already incorporated into revenue and profit calculations — if profits go up they go up, no inflation discounting necessary.

What about workers? Well, as we said, interest rates go up.

That means that if you are borrowing — mortgages, car loans, credit cards — your cost of living goes up further. The same goes for people who are exposed to debt in any way; for example, people who rent from a landlord with a mortgage. Repayments go up, rent goes up, and now you have less money. This is the devastating one-two punch that most Australians will experience; the rising cost of living through consumer prices, and rising costs of debt and housing.

Despite the tone that most media commentators set — families will “feel the pinch” — this is not some passive by-product or unfortunate side-effect of an ethereal economic interaction; it is the entire mechanism. When the RBA speaks of ‘cooling aggregate demand,’ they mean they need you to spend less money — and the only way they can make this happen is to make sure you have less money. All the earlier sidebars about inflation mechanisms and buyers bidding up prices are again relevant here; their aim is to make sure buyers are unable to bid up prices, even in the face of supply shortages.

This means choosing between strawberries and blueberries instead of buying both, choosing the cheddar instead of the brie, or not turning the heater on this winter. It means kids staying or moving back home and not entering rental markets, it means not being able to afford holidays, it means a reduction in every area that people spend money. Whatever the specific case, the aim is the same: to make some portion of the population unwilling or unable to enter consumer markets. The hope is that this will cause demand to fall to match available supply, and that inflation will return to the 2–3% target — all this not aimed at reducing prices for struggling Australians, but at making sure they continue to rise more slowly.

These may not sound like terrible sacrifices for the professional managerial class or high-earning dual income families — although I’m sure if you ask them they are still not happy about having less money — but for the most vulnerable people in Australia it is devastating. As always, the burden will fall disproportionately on First Nations peoples, single mothers, older women, pensioners, minority communities, the un- and underemployed, and on the huge number of Australians working multiple, insecure, minimum wage jobs. While the nominal impact — the number of dollars they lose — may be smaller, the impact on their lives will be enormous if we believe that the solution to a cost of living crisis is to increase the cost of living.

What Is To Be Done?

There are three interrelated points to make in conclusion. The first is that, as a short-term solution, we must increase wages. If there is little we can do to address the external causes of global supply-side inflation, then we must address the other half of the equation; if we cannot reduce the cost of living to keep parity with wages, we must increase wages to remain in line with costs.

According to Treasury, wage increases up to the value of inflation plus productivity increases do not increase the risk of future inflation. The basic idea is that if wages and inflation grow hand in hand there is no net gain or loss on either side. Additionally, if productivity rises it increases the supply of goods in the market; this increased supply allows for demand to increase — in the form of higher wages — without putting pressure on inflation.

Anthony Albanese understands this, as do the Treasury department and the economics-graduate Prime Minister, which is why the debate over the call for an inflation-matching increase to the minimum wage is cynical at best.

The other people who understand this in even more intimate detail are the people who are seeing their cost of living skyrocket while their paychecks remain the same. They know they are not driving inflation, they are trying to bring home the same basket of goods they did the week before. If they are forced to pay higher prices, it is because prices have been raised well outside of their control — there is no bidding up of prices happening here. These are the people who are demanding, in a much more material way than Albanese, that their comfort and wellbeing are not sacrificed on the altar of the economy: the striking sanitation workers, bus drivers, aged care workers, nurses, teachers, and other real people who are our economy, and who make it function.

This leads to the second point, that when we deal in abstractions and generalisations we risk doing very real harm. It is very simple and sensible to say that when inflation is rising, we should raise interest rates to save the economy. It is much less simple and sensible to say that when consumer prices are increasing, we should also increase the cost of debt and housing to improve the lives of people in Australia.

Saving the economy and improving the lives of Australians should be the same thing.

This is not to say that we shouldn’t use theoretical constructions to help manage the towering bureaucracy of the nation-state, but that we must keep in mind the real implications of these abstract decisions. Using generalised measures to approximate material conditions is all well and good, but we must keep our goals and policies focussed on the thing being measured, not the measure itself.

The final point is this. The RBA is not some evil overlord, nor does it specifically hate you. It is simply a dispassionate institution that plays by the rules of neoclassical economics. Those rules just do not care about you, nor acknowledge your existence as more than a data point. These rules are not artificial; they are real, observable phenomena that govern economic interactions within a free-market capitalist society. Any steps that our governing institutions take within such a framework must adhere to these rules, tinkering with fiscal policy to soften the blow of the monetary sledgehammer. But we need not use these inexact, indirect, and unpredictable tools to filter and influence market interactions in the hope that the outcome will be somehow better. The rules of football are real, observable phenomena that govern interactions within a game of football, but we don’t have to play football.

If consumers have more money, then a profit maximising business will raise the price of their goods to the maximum that the market can bear. Our potential solutions to this problem, within the rules of the current dominant economic paradigm, are limited, but this just displays a lack of imagination. There is no law of nature that says a business must exchange goods for the profit-maximising price; this is based on a whole host of other assumptions and decisions that are built into our economy.

There is no divine mandate that says those who work in a business and those who own a business must be distinct groups of people; that corporate profits must be maintained and increased; or even that production must make any profit above the costs of capital and labour. We can choose to make different decisions and organise things differently. These things are not laws of nature, they are laws of profit-driven, supply and demand economics — and, much like football, we can choose to stop playing.