Prices are rising. But does anyone know where inflation’s heading?

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It’s unnerving watching economists arguing about something you’d think they would have figured out decades ago.

I’m talking about inflation.

At the moment, macroeconomists the world over are arguing about the recent uptick in inflation in places like the United States.

They want to know what it means. 

Is it anything to worry about? Do we have the right tools to manage it? Will it damage our economies like it did in the 1970s? Or is it more like the inflation from the 1950s?

It’s a huge topic. But let’s keep things simple.

Let me explain quickly what inflation is.

Then I’ll show you why some economists think policymakers can’t forecast inflation very well, and why that’s a big problem.

What is inflation?

Inflation is one of the most important phenomena in economics.

It can also be a major driver of historical events: when inflation gets out of control, it can cause empires to collapse, societies to crumble and wars to begin.

So what is it?

At its most basic level, “inflation” refers to a general rise in the level of prices in an economy over time.

It’s the phenomenon that explains why a unit of currency can buy fewer goods and services as the decades roll by.

You can see what that means by looking at old advertisements like the Chrysler ad below, which was printed in Australian newspapers in 1973.

This Chrysler ad was published in Australian newspapers in 1973.

You couldn’t buy a brand new car like that for $7,400 today.

It shows how the value of an Australian dollar — the purchasing power of the currency — has deteriorated significantly in the last 48 years.

And that explains why weekly wages have to be so much higher than they used to be.

In the June quarter 1973, average weekly ordinary time earnings were roughly $100, but in the June quarter this year, they were $1,737.

A large part of that increase was necessary because the level of prices has increased so much.

In fact, between 1973 and 2020 the annual rate of inflation was 4.9 per cent.

An item costing $10 in 1973 cost $96.75 in 2020.

A dollar ain’t what it used to be.

Where does inflation come from?

We’ll get through this bit quickly.

Inflation comes from many sources, but let’s consider three.

Imagine a situation in which everyone in the country is given $100,000 each and we all rush out to buy a particular good.

If producers don’t have time to increase the supply of that good to match the extra demand, there’ll be all this extra money competing for the goods, so prices will rise to meet the extra demand.

Or consider a second situation.

Imagine a situation in which production costs, such as raw materials or wages, suddenly surge for some reason. 

A producer might try to protect their profits by passing those higher input costs onto customers in the form of higher prices for their final goods.

Or consider a third situation.

Think of how, during wage negotiations, you always want your wages to increase a little faster than inflation so your after-tax pay packet isn’t slipping backwards.

If your bosses agree to lift wages a bit they might try to pass those higher labour costs onto their customers, in the form of higher prices, which leads those customers to ask for higher wages from their bosses.

So inflation can be built into the system in a feedback loop, as producers and consumers constantly jostle for a little bit of extra money through time.

Another dimension to consider

But there’s one more dimension which is really important.

It has to do with the duration of a change in prices.

If the prices of some goods and services start increasing more than normal, will the price spikes be temporary, or slightly longer-term, or will they become a structural change?

The answer is crucial.

Why? Because if the price spikes are temporary the economy should be able to absorb them without too much damage.

But if the price of a vital input in the production process — such as oil — surges and stays high for a long period, it can damage the global economy.

In the 1970s, the price of oil jumped dramatically a couple of times and remained elevated.

It saw the cost of production surge for a range of goods and services, which pushed costs higher. The higher costs hit demand, slowing economic growth. And workers regularly demanded higher wages to keep up with rising prices, which fed into the wage-price spiral.

There was a lot going on in the 70s, so that doesn’t explain all of the surge in inflation in that decade.

But it was an important element.

And the outbreak in inflation was severe enough that it convinced Australia’s policymakers to restructure the economy in radical ways, to try to get inflation back under control.

In the four decades since, policymakers have lived in fear of it happening again.

What’s happening to inflation?

This brings us to the final section.

It’s what makes the current argument about inflation so fascinating.

As the global economy recovers from its COVID-induced lockdowns, there’s been an uptick in inflation this year, particularly in the United States.

Global supply chains have been damaged and it’s pushing higher costs into the system.

Think of how the global semi-conductor shortage has contributed to a shortage of new cars and how that’s seen the price of second-hand cars surge too.

Economists are arguing about the meaning of the inflation: is the inflation temporary or will it be longer-lasting?

At the moment, institutions like Australia’s Reserve Bank, the US Federal Reserve and the International Monetary Fund think the higher rate of inflation will be temporary.

But not everyone agrees.

Last month, the European Central Bank held a two-day forum to discuss what monetary policy might look like in the future, and it included a debate on “the future of inflation.”

One of the panellists in that debate, Charles Goodhart, set some fireworks off.

Goodhart is professor emeritus at the London School of Economics. He’s as establishment as you can get. Eton College. Trinity College at Cambridge. A PhD from Harvard in 1963. A long-time senior official at the Bank of England.

The 84-year old had some things to say.

Economists have no general theory of inflation?

Professor Goodhart told the forum the world was in an extraordinary situation at the moment because economists had “no general theory of inflation.”

Come again?

He said economists used to have two theories, but those theories had lost credibility.

“One of these was the Friedman monetary theory that inflation is always and everywhere a function of too much money chasing too few goods,” he said.

“Now that theory has become so discredited that central banks now, as a general matter, do not even mention monetary aggregates at all, and seem embarrassed to do so.

“Then of course there is the somewhat interconnected Phillips Curve, the relationship between the natural level of unemployment and the rate of inflation, and that has also been behaving rather oddly.”

He said the vacuum had been filled by a “bootstrap theory of inflation” in which economists assumed that inflation depended on peoples’ expectations of future inflation.

“Now this is, unfortunately, a very weak reed,” he warned.

“It’s a very weak reed because actually, inflation expectations are much more associated … with what has happened in the past, from which people tend to extrapolate, than what is likely to happen in future.”

But let’s skip the technicalities.

What does Professor Goodhart think will happen to inflation in coming years?

Cyclical and trend inflation will start rising

He thinks the world is going to experience both a cyclical and trend increase in inflation, driven by major demographic changes and the next chapter in globalisation.

On cyclical inflation, he said central banks were planning to keep monetary policy very accommodative in the next few years to push unemployment down to levels not seen in decades.

“That is going to mean that cyclical inflation is going to rise,” he said.

On trend inflation, which refers to longer-term dynamics, he said working-age populations would start declining in many countries as populations age.

And that would see the global labour supply shrink in coming decades.

“All of the factors that have led to an increase in labour, the reduction in bargaining power that went with it, the decline in trade unions etcetera, all of that will now reverse,” he said.

“It [will make] the availability of labour, from having been coming out your ears, to being hard to find, and people will bid up wages in order to deal with the shortages of workers that they will increasingly be facing, not just temporarily.

“That’s not transitory. It’s here for the long run,” he said.

And to top it off?

He said the current unprecedented surge in property prices globally would feed into the inflation dynamics in coming years.

At any rate, if you’re interested in more you can watch him in the video below from the 15-minute mark.

Enjoyably, the other panellists did not agree with him.

They continued to assert their “bootstrap theory” of inflation.

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