kewpid.net

In day-to-day life any kind of price rise is blamed as infla­tion (or price gou­ging!). But this is tech­nic­ally incor­rect. A price rise on any one thing is just a price rise, it is not infla­tion. Strictly, the text­book defin­i­tion of infla­tion is “a sus­tained increase in the gen­eral level of prices”.

There is no easy way to meas­ure infla­tion, and the best tools we have are prox­ies in the form of vari­ous price indexes. The most well-known is the con­sumer price index (CPI) which tracks a ‘bas­ket’ of goods and ser­vices rep­res­ent­ing com­monly bought things.

Infla­tion can be an insi­di­ous thing, erod­ing the value of people’s cash sav­ings, and redu­cing their pur­chas­ing power. It also has a tend­ency to accel­er­ate out of con­trol if it is not con­tained. The most fam­ous example is the hyper­in­fla­tion in Ger­many in the 1920s, which got so bad people had to push around wheel­bar­rows of cash to buy loaves of bread.

Australia’s Reserve Bank (RBA) has an expli­cit policy of “infla­tion tar­get­ing”, where it tries to keep the annual rate of infla­tion (CPI) between 2 and 3 per­cent over the course of the busi­ness cycle. The RBA achieves this through changes in the ‘cash rate’, which is the mar­ket interest rate on overnight funds lent to banks and fin­an­cial insti­tu­tions. The cash rate is used as a baseline that affects most other interest rates, includ­ing mort­gages and busi­ness loans. Increases in the cash rate have a tend­ency to reduce levels of busi­ness invest­ment and con­sumer spend­ing and vice-versa. Changes in the cash rate there­fore have rever­ber­a­tions across the entire eco­nomy, affect­ing over­all spend­ing and borrowing.

Infla­tion tar­get­ing was intro­duced in 1993 and has been sin­gu­larly suc­cess­ful in anchor­ing infla­tion expect­a­tions, keep­ing CPI increases stable, and under­pin­ning Australia’s eco­nomic growth. You can see in the graph below that CPI increases oscil­lated wildly before 1993, but have since mostly stayed in the RBA’s 2 – 3 per­cent tar­get band.

The CPI starts to wobble again towards the end of the graph as the income surge from Australia’s min­ing boom starts cre­at­ing price pres­sures across the eco­nomy. The uptick at the very end is attrib­ut­able to the hangover caused by the RBA dra­mat­ic­ally cut­ting the cash rate from 7.25 to 3.25 per­cent over the course of 2008-09 in the face of the global fin­an­cial crisis.

The most recent stat­ist­ics have the CPI run­ning at 3.6 per­cent, fuelled by increases in the cost of fruit (up 26.9% in the three months to June), pet­rol (+4.0%) and health ser­vices (+3.4%). This was off­set by decreases in the cost of veget­ables ( – 10.3%), com­puter equip­ment ( – 6.3%) and elec­tri­city ( – 1.5%). Although some of this is attrib­ut­able to nat­ural dis­asters and external events, the CPI is still at the upper bounds of the RBA’s target.

Through agree­ment between the RBA Gov­ernor and the Treas­urer, and the State­ment on the Con­duct of Mon­et­ary Policy, the RBA’s man­date is to address this breach of its infla­tion tar­get. If the RBA were a purely infla­tion tar­get­ting cent­ral bank, it would have raised rates on Tues­day. The RBA’s staff eco­nom­ists pushed for an increase. Read­ing between the lines of its state­ment, ele­ments of the RBA Board would also have pre­ferred to raise rates. The ten­sion lies squarely on the Board itself, which is pop­u­lated by industry fig­ures whose busi­ness interests, par­tic­u­larly in retail, are cry­ing out for rate cuts.

Against the back­grop of ongo­ing debt and eco­nomic troubles in the US and Europe, the next 12 months will be fascinating.