Date posted: 24/04/2020 10 min read

Why slaying the inflation dragon isn’t good for business

Double-digit inflation was a thing in the 1970s and ’80s. Today, inflation could hit zero – and that’s bad for business.

In Brief

  • Back in 1980, inflation was erratic from year to year and on average, high and persistent.
  • Inflation in Australia and New Zealand is too low compared with the RBA’s RBNZ’s current targets.
  • Low inflation is bad because it impacts on price adjustment and stops people from purchasing goods.

For accountants – and economists – nearing the end of their careers, the current inflation rate has been one of the most remarkable changes in the business environment. Yet for those just embarking, it’s completely taken for granted.

Back in 1980, inflation in Australia was 10%. In New Zealand it was 17%. Inflation was erratic from year to year but, on average, high and persistent. What cost A$100 at the start of the 1970s cost A$257 by the end of it. New Zealand was worse again – you needed NZ$311 to buy what had cost you NZ$100 a decade earlier.

Yet today we are in a wholly different world. Barring the odd GST-related spikelet, inflation has been in low single-digit numbers for more than 25 years. The graph below includes the International Monetary Fund’s forecasts for this year: more of the same, with inflation expected a bit below 2%. Other forecasters tend to agree.

40 years of inflation40 years of inflation. Source: IMF World Economic Outlook database. Click image to enlarge.

How did this inflation transformation happen?

It took three things to get here. One was the political will to change. The public was sick of high inflation, but it wasn’t until markedly different politicians took over in the UK (Thatcher in 1979), the US (Reagan in 1980), Australia (Hawke in 1983) and New Zealand (Lange in 1984) that anything got done.

Another was a readiness to tolerate the costs of change: temporarily higher unemployment and lost output.

The last one was better macroeconomics. The pollies might have wanted to do something, but they and their economic advisers were clueless. Their best attempt, daft though it sounds now, was “I forbid it!” by way of regulatory wage and price freezes.

It took a while, but the macroeconomists studying inflation eventually got their act together. Gradually, all four countries, and a lot of others, signed up for the new and improved economics: today’s monetary policy regime of an operationally independent central bank focused on a specified inflation target.

Here endeth the economic history lesson. Now let’s see how it applies to today’s inflation problem.

Missing the inflation target

Inflation in Australia and New Zealand is too low compared with the RBA’s target (2% to 3% over time) or the RBNZ’s (1% to 3% with a focus on 2%). Other central banks, notably Europe’s and Japan’s, have the same problem. Central bank governors were meant to tame the inflation dragon, Daenerys Targaryen style. Instead, they’ve killed it.

“Central bank governors were meant to tame the inflation dragon, Daenerys Targaryen style. Instead, they’ve killed it.”

You might feel that too-low inflation is a first world problem. And whether inflation is 1% rather than 2% certainly doesn’t stand much comparison with whether it is 10% rather than 20%. But for a variety of reasons it’s still not a good thing.

For example, a market economy only works properly when prices are able to adjust compared to others. A 2%-ish level of inflation doesn’t make a big difference to the economy overall, but in a modest way it still allows relative prices to adjust without one of the price setters having to outright cut theirs – not an appealing prospect if one of the prices is your hourly rate.

You especially don’t want inflation dropping below zero. If that happens, people start thinking things will be cheaper next year, and they stop buying today. And there’s a bunch of technical reasons around the mechanics of price measurement that get you to “aim for 2% or so”.

At the moment, though, our aim is off. If, as the economic history of the 1980s shows, the way out of here needs a combo of political will, readiness to bite any associated bullets, and better economic technique, we’re not in a good place.

The danger of unconventional economic weaponry

It’s true the pollies could make an example of reserve bank governors Philip Lowe and Adrian Orr for failing to hit the inflation target, but I doubt it. When the performance reviews come around, it’ll be hard to berate them for being in the same place as their bigger central bank colleagues. And while there is widespread grumbling about the slow pace of wage increases, there isn’t the same head of political steam about too-slow price increases.

But it’s the economic techniques, and their potential costs, that bother me most. At the moment, if common or garden monetary policy hasn’t got you to 2% inflation, the accepted way forward is to use ‘unconventional’ monetary policy. Both Australia and New Zealand have signalled they’re open to using it. That means oddities such as negative interest rates, where lenders pay borrowers.

As I write, if you buy a Swiss government 10-year bond you will pay the Swiss government 0.75% a year.

Quantitative easing includes central banks buying vast quantities of bonds to keep long-term interest rates down. At its most extreme, it extends to rolling the presses and printing money. These have the potential to be nastily disruptive.

Think what you like of the banks in this post-Hayne world, but they serve socially useful purposes. They won’t work as well when even conservative depositors won’t leave their money in a bank account, nor when businesses are tanking up on effectively subsidised credit. As has been widely noted, quantitative easing makes already large wealth inequalities wider by boosting bond and equity prices, as well as raising the risk of asset overvaluation boom and bust.

And what happens when some of those corporate bonds our reserve banks buy go bung? Before, it was the bond investors’ problem. Now, it’s the taxpayers’. Is that fair or efficient? As for printing money, let’s just note that such a policy, rebranded as People’s Quantitative Easing, was proposed by former UK Labour leader Jeremy Corbyn in 2015, and leave it at that.

It doesn’t help (as I wrote in Acuity August 2019) that there still isn’t any clear diagnosis of exactly why inflation is so low. Deploying this unconventional battery when you can’t see the enemy clearly doesn’t make complete sense.

All up, if inflation stays too low, and we want to fix it, we could go the route of unconventional monetary weaponry, or we could boost the economy (and inflation with it) with fiscal policy. I know which way I’d go.

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