Inflation, To Be or Not To Be?

Is inflation in the offing? That is the question. As Milton Freidman so expertly put it, inflation is everywhere a monetary phenomenon. What he meant by that is that you can’t have inflation unless the money supply expands and fuels a demand for goods and services that can’t be met. Now, in any particular instance, as happened in the past, inflation might be triggered by, say, wage rises or by rises in oil prices. However, this triggering will not lead on to inflation unless accommodated by increases in the money supply.

To be clear, inflation is a general and continual rise in the prices of goods and services – usually beyond a modest level. So, a general rise in prices of anything over, say, 4 to 5 per cent a year might be called inflation whereas up to 2 to 3 per cent a year might be called nothing at all, or welcome.

There is often talk about asset price inflation. Ignore it. This is not inflation. Some asset prices rise when interest rates are pushed to low levels by central banks. This usually means that central banks are in the market buying up bonds, as they are currently doing. This results in increases in the money supply, but it is a mistake to leap from that to asset price inflation.

Overall, it is misleading to talk about asset price inflation when interest rates are low. What usually happens is that some assets become worth relatively less than they were – those which pay interest (e.g., holdings of bank deposits and newly-issued bonds) while those assets which to a large extent live off borrowing (e.g., houses, commercial buildings and to a lesser extent shares) rise in value. Without stretching the point too far, it is a sort of zero-sum game, though only the upside is usually counted. Stuff pensioners with bank deposits.

Inflation, as it should be commonly understood, is applicable to goods and services only. And, by the way, hyper-inflation of the kind that struck the Weimar Republic or Zimbabwe or revolutionary France can only happen if fiat paper money is the main means of transacting business. Wheelbarrow loads of Reich Marks are a thing of the past; at least in modern Western economies. Overwhelmingly now in modern economies bank deposits are the means of making payments. Bank deposits, in turn, are mainly generated by commercial bank lending.

Central banks have substantial control over commercial bank activity and would stymie runaway inflation before it got going. But that is not to say that we can’t have uncomfortable rates of inflation of the kind that happened, for example, under the Hawke-Keating government in 1986, when inflation reached a little over 9 per cent. During the two-year period from the end of 1984 to the end of 1986, M1 money (cash and at-call bank deposits) increased by 21 percent and M3 (a broader definition, including time deposits) increased by 25 percent. Ample enough money sloshing around to fuel inflation.

How about now? In the two years from February 2019 to February 2021, M1 money has increased by a whopping 60 percent (rounded); M3 money by a much lower but still sizeable figure of 15 percent. Why the difference? Well, these days, the benefit of switching out of call-deposits into time-deposits is marginal to say the least. The bottom line, however, is that there is enough money supply around to fuel inflation. As an international comparison, in the United States the money supply corresponding to our M3 has grown by 36 percent over the two years. More than enough money there too to fuel inflation; as, in fact, there is across most countries.

Will inflation take off?

Quarterly ups-and-downs aside, consumer prices in Australia rose by only 1.1 percent over the year from the March quarter 2020 to the March quarter 2021. The annualised rise in the March quarter was 2.6 percent. Perhaps that indicates some very modest upward pressure on prices? The annualised rate of inflation in the US also rose a little to 2.6 percent in March 2021 from 1.7 in February. But really, the data thus far does not point to any immediate take-off in inflation. However, care is needed.

The disruption cause by governments overwrought responses to COVID is still very much about. Some sectors of economies, related to travel and to entertainment particularly, are operating below capacity. Unemployment remains higher than it would be in normal circumstances and this is keeping wage rises in check.

It is fair to say that the kind of economic activity and spending which could be generated by the prevailing money supply might be still be in the wings waiting to happen. We shall have to wait and see. It won’t be pretty if it happens. Higher interest rates. So much government debt to finance and refinance.

As a final point, some commentators suggest that China is a safety valve which will prevent inflation. No more inflation. Spending gets too high. OK, China builds a new factory to supply even more tawdry goods on the cheap. Economics has this covered in theory. The Yuan should rise in value making goods landed in Australia and elsewhere more expensive in local currency. But just suppose, perish the thought, that China manipulates its currency to keep its value down? Then what?

I don’t know, China wasn’t in the textbooks when I studied economics. Or, for that matter, when Milton Freidman was doing his thing.