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.

He made the interesting observation that economics split off from the “harder” sciences well before certain fundamentals had been established, and so what we have now is a discipline that is incestuously self-contained and unwilling to embrace outside ideas. On top of that, economists’ desire to be taken seriously has led them to “rigourise” their discipline by importing mathematical and econometric models. Gittins feels that these models are simply inadequate in accounting for the totality of human behaviour.

Gittins also attacked the central assumption in economics – that humans behave rationally. He pointed to people’s desire to balance work and life, giving gifts, conspicuous consumption, and an overriding “fairness” mechanism that all question the rationality assumption.

While Gittins’ criticisms of the economics profession are certainly valid, he seems to broadly ignore that many of his gripes are increasingly dealt with in behavioural and heterodox economics. His paternal father-knows-best criticism of people’s spending habits is not credible given the surprisingly stable level of income spent on consumption over the past 50 years. His grumble that there is too much physics and not enough psychology in economics has been taken up the orthodoxy.

All-in-all it was a pretty waffly talk. I amused myself by folding paper ties. Enoch was particularly bored.

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has an interesting article mooting the pros and cons of a deliberately engineered recession in the United States. From a purely technical point of view, there is no reason why this is inconsistent with the Federal Reserve’s mandate. Central banks these days work on the principle of inflation targeting to ensure price stability and a smoother economic cycle. If monetary policy effects a mild recession today to prevent a much harsher one in the future then that is the appropriate policy (or so the theory goes). Further, economic downturns “weed out” inefficiencies in the economy and force the recapitalisation of more efficient industries.

All of this is perfectly logical to an economist.

But most people are not economists, and it’s difficult to imagine why they’d wear the human cost of a recession. Yet in the best example of this in Australia, the recession of 1991–92, people did wear it, and went on to re-elect the man who engineered it.

But does Australian history present any guidance for the current U.S. situation? There are important differences. America’s foreign debt is far higher than was the case in Australia and it is coming out of a credit-fuelled binge. Raising interest rates would mean taking the cane to those with mortgages, and an admission that the Federal Reserve was too lax with monetary policy in 2001-02.

The Economist

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notes that:

… even if a recession were in America’s long-term economic interest, it would be political suicide. A central banker who mentioned the idea might soon be out of a job. But that should not stop undiplomatic economists asking whether a recession once in a while might actually be a good thing.

Whatever outcomes are pursued, it is reassuring that such decisions are made by independent central bankers and not self-interested politicians.

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, the global savings glut produced some rather lopsided outcomes, many of which are now coming home to roost. The ready availability of credit and basic greed fuelled the American sub-prime market, and now the world’s stock markets and currencies are paying for it.

Over the past fortnight, the Australian Dollar has ranged between 0.78 and 0.89 USD (hyooooooge!), with the bigger number occurring before the smaller one (i.e., we’ve devalued hugely). There’s also been a corresponding reduction in the Trade Weighted Index (TWI), so that’s a depreciation against all major currencies.

Although there’s been turmoil in the financial markets, I’m not convinced this will have any substantial effect on Australia’s real economy. The Aussie dollar’s recent commanding heights were invariably going to be short-lived (I bought some stuff from Amazon.com just in the nick of time to take advantage of this), and even at its current level is still slightly above its long-run average. The All Ordinaries Index’s almighty slump this week just means it is back to where it was at the beginning of the year. If anything, it represents an excellent buying opportunity. Forgive me for feeling unsympathetic that a few investors lost a bundle.

In more money topsy-turvy, the federal government has introduced the Higher Education Endowment Fund Bill into the parliament. Putting aside the silliness of underfunding higher education for a decade, and thinking it can all be undone with a less than adequate capital injection, Andrew Norton points out

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that the Bill makes provision for tax-deductible contributions by members of the public. That is, out of the goodness of your heart, you can give money to the federal government. Who would do that in preference to a direct donation to a university? At the time of the 2007/08 Budget, there was tussle between Peter Costello and Julie Bishop, about who actually came up with the idea for the HEEF. Was it the self-tooting Economic Master™, or the lightweight Minister for Education? Too bad this isn’t an issue of enough import for any blame-shifting. Otherwise we’d all find out that it’s the state Labor governments’ fault.