Had a blog on Quadrant Online on inflation. Basically gazumped by the Voice. So I thought I would share a slightly condensed version. Who knows some people might still be interested in economics, what with the Voice, climate change, transgenderism, and what not going on.
There’s lots of talk about Philip Lowe’s tenure at the Reserve Bank (RBA). He did very little wrong that other central bankers didn’t do. He was just too plucky in airing his ponderings that rates would remain close to zero until 2024. It would have served him better, as Yogi Berra and others reputedly said, to never to make predictions [aloud], especially about the future.
Central bankers are not free spirits. They tend to move as a pack. They all brought down interest rates too low and allowed inflation to gather speed. Then once it gathered speed their Keynesian economics, which led to the problem in the first place and which they all share, gives them no clear guidelines as to when enough is enough of interest rate increases.
You get this silly business of watching the latest inflation figures to guide policy. Economics 101: lags mean that the effect of policy is seen down the track. Current observations are usually misleading.
Another plague on good policymaking is to look at the relationship between interest rates (official cash rate now 3.35 percent) and inflation (December quarter 7.8 percent) and conclude that the real interest rate (3.5 minus 7.8) is negative and thus rates need to rise much further.
Current inflation is an irrelevant variable. Inflationary expectations are what count. And it seems likely that the current expectation is that inflation will fall. Equally, the interest rate to be considered is not the cash rate but the rate at which money can be borrowed by households and businesses and, moreover, set against the anticipated return on the money borrowed. Business is much more likely to be gung-ho when borrowing at, say, 7 percent when 17 percent is to be made, than if only 10 percent is to be made. It’s too complicated and we shouldn’t bother with it.
Instead of focusing on interest rates central banks should go back to Milton Friedman and focus on the growth of money aggregates. Inflation is a persistent increase in the prices of goods and services taken as a whole. Equivalently, it is a persistent reduction in the value of money. What leads to such a persistent reduction in the value of money? Creating too much of it.
These days most money consist of bank deposits and the creation of most money is through bank lending. Nevertheless, the root cause, as ever, is governments spending more than they raise in taxes and borrowings. In turn, this increases deposits held by banks in central banks which provide the wherewithal for banks to lend.
What the RBA should do is to adjust interest rates to keep the growth in monetary aggregates under control. The focus should not be on the level of interest rates. That’s the instrument. The focus should be on the growth of money; that’s the target. Sure there are three or four different definitions of money. But an average of them all would do, save picking one – which would also probably do.
In the two years, between December 2019 and December 2021, according to RBA figures, M1 money (cash plus bank current a/c deposits) increased by over 50 percent. M3 money (M1 plus other deposits in banks and in other authorised deposit-taking institutions) increased by over 23 percent. During the same two-year period the economy (real GDP) grew by just 5 percent. Bit of gap there. And it’s no surprise that excess monetary growth eventually finds its way into rising prices.
M1 peaked in May 2022 and has been trending down since. M3 is still going up but at a much reduced rate. Bank lending provides an early indication of what’s happening and the RBA should have intelligence on the very latest figures. The question is whether the RBA is focusing on the right variables – bank lending / monetary aggregates – or whether it remains besotted by the latest CPI figure. If it’s the latter it is bound to get it wrong in raising interest rates too much, as it got it wrong in reducing them too much.