Cost-push or demand-pull inflation?

The RBA is fighting inflation with higher rates but how effective will it be without suitable fiscal policy support?
John Abernethy

Clime Asset Management

Way back in 1976, I well recall that in the HSC unit 3 Economics exam, students (including me) were required to describe the difference between “cost-push” inflation and “demand-pull” inflation. In those days, both the world and Australia were battered by rolling inflation caused by an oil crisis and the geo-political consequences that flowed from conflict in the Middle East.

Given current elevated inflation, I suspect that this year’s HSC Economics students may be confronted by a similar question. Further, as an extension question, students could be asked to advise on the policies which the Government’s fiscal policy and the Reserve Bank’s (RBA) monetary policy should employ to rein in inflation.

Both questions and answers will be of particular interest to our governing authorities as they battle with the inflationary threat - particularly at a time when both government debt and mortgage debt will be forced into higher interest rates. Indeed, the success of current economic management may well support or hinder this year’s HSC students as they venture from study into the workforce.

In passing, I note that in 1982, five years after my HSC and when I had graduated from university, Australia was deep in recession, jobs were hard to find and inflation remained elevated. In retrospect, history shows that the economic management of the 1970s was dramatically dealt with by bold policy adjustments: the lowering of trade barriers, the floating of the AUD, and a national focus on developing industries in which we exhibited comparative advantage.

If I were answering my 1976 question today, I would suggest that Australia’s inflation is about 80% cost driven and about 20% demand driven. 

By inflation, I am specifically referring to the cost of living for households and ignoring asset price inflation (eg. residential house prices) which rocketed when cash rates fell to near zero.

The weighting to cost push inflation is important because it requires a stronger fiscal response than a monetary (or cash rate) adjustment. 

It also requires fiscal policy and monetary policy to act in a complimentary fashion. For instance, fiscal policy that utilises taxation rate adjustments could be used to increase after tax salaries for low income earners, and drop the prices of essential services such as electricity or petrol. Meanwhile, monetary policy that acknowledges that fiscal stabilisers to inflation are being utilised could refrain from aggressively pushing up mortgage or lending rates that add to the cost of living.

The higher weighting to cost inflation recognises the lingering effects on supply lines caused by Covid-19 (particularly from China) and the outbreak of war in Ukraine. The inflationary effects of these events will continue to dissipate throughout 2023 and next year. Rising interest rates will not hasten the inflationary decline. Further, rising interest rates will not alleviate the cost pressures affecting the household sector – whereas targeted taxation adjustments will. Rising rates on mortgages will actually increase the cost of living faster for heavily borrowed households than any official measurement of inflation.

So can we afford taxation adjustments through fiscal policy? This is where a high school economics student could show real astuteness by stating that Australia’s fiscal policy should avoid causing a recession. To explain this, the student need only describe how economic stabilisers in fiscal policy operate in response to an economic downturn.

Simply stated, a recession (particularly an RBA induced one) creates higher unemployment, lowers taxation collections and increases the fiscal deficit for a sustained period. In turn, it increases the government debt load and at a faster pace than deficits targeted at reducing inflation and avoiding recession. When a recession is caused by higher interest rates from monetary settings, the higher rate structure flows into higher bond yields and lifts interest payments payable by the government for many years. The outlook for government deficits and debt is worsened. 

Therefore, we can certainly afford to avoid a recession, whilst we probably cannot afford to create a recession.

The difference between cost and demand inflation is critical to understand. It is also important to note that the measurement of inflation is a construct that often changes. Further, as noted above, some significant “costs of living” are simply ignored in inflationary calculations.

Given this, how important is it to aggressively target an inflationary outcome when that outcome is greatly affected by events that were largely unforeseen, unavoidable and unmanageable? Further, if inflation was incredibly low for a few years (2019 through to 2021), then why not accept slightly elevated inflation for a few years?

In terms of economic policy, we are currently informed by the RBA that cash rates will continue to rise. However they have not articulated their argument how this will lower the cost of living to households. Whilst they acknowledge that unemployment will rise and wages (hopefully) stall – is this a real measure of success? Indeed, if rates rise to a point where they quickly have to be adjusted back down, then is this not a failure of monetary policy?

Meanwhile, the government ignores policies designed to reduce inflation and taxation adjustments that will increase take home salaries for those most affected by the rising cost of living.

Policy inertia, rising cash rates, weakening bond markets (higher yields) and a lack of economic thought leadership is not good for investment markets. Therefore, after its solid bounce since late 2022, we can expect that equity markets will drift along, dominated by international events, until we hear from the Treasurer in the May budget.

In that budget, the Treasurer will announce a remarkably strong fiscal outcome for FY23. He will also have to acknowledge that the million immigrants that will enter Australia over the next 5 years will support a robust growth outlook – so long as they can afford to live here.

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John Abernethy
Clime Asset Management

John has 35 years experience in funds management and corporate advisory services. Prior to establishing Clime, John’s roles included ten years at NRMA Investments as the head of equities. Clime is a management and advisory business for mainly SMSFs.

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