Money is the Root of all Inflation

There’s lots of talk about Philip Lowe’s tenure at the Reserve Bank (RBA). As we read in The Monthly — those of us with strong stomachs, that is — Jim Chalmers wants to “renovate” the RBA. Normally renovation doesn’t include decapitating and replacing the head of the household. But who knows what’s in jejune Jim’s leftist mind. Lowe must be nervous, come September, of being denied another seven years at the helm. On the other hand, for all I know he has more exciting things in prospect and will resign before they get a chance to sack him.

Enough of this idle talk. First,  an excuse for Lowe.

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 predict (especially aloud) about the future.

That aside, it’s best to remember that central bankers are not free spirits. They tend to move as a pack to avoid being the maverick, which isn’t a good look in central bank circles. 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, have given them no clear guidelines as to when enough is enough of interest rate increases. They are misled on the way down and on the way up.

One result is that you get this very silly business of watching the latest inflation figures to guide policy. The media don’t help. Economics 101; to wit, says lags mean that the effect of policy is seen down the track. Current observations are usually misleading.

The other plague on good policymaking is to look at the relationship between interest rates (official cash rate now 3.35 per cent) and inflation (December quarter 7.8 per cent) and conclude that the real interest rate (3.5 minus 7.8) is negative, and thus do rates need to rise much further. I note that some pretend economists fall into this trap for simpletons. The current inflation is an irrelevant variable. Inflationary expectations are what count. And it seems likely that the current expectation is for inflation to 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 very complicated, can’t be calculated, 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. (I covered this more fully last year.) It’s not hard, which is perhaps why economists shy away from it. After all, if your next-door neighbour can understand it, what was the use of all that studying? 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? “Printing” too much of it.

Printing connotes wheelbarrows of (paper), assignats in revolutionary France and Papiermarks in the Weimar Republic. These days most money consists of bank deposits, and the creation of most money is through bank lending. Nevertheless, too much of it causes inflation and 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 is the RBA (and other central banks) to do? Persuade the government to be less spendthrift? Forget that one, particularly if a Labor government is in power.

What the RBA must 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 per cent. 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, except apparently to central bankers, that it will eventually find its way into rising prices.

What have monetary aggregates done in 2022. Well 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.

3 thoughts on “Money is the Root of all Inflation

  • BalancedObservation says:

    At times I might have a few disagreements with Peter Smith but there’s one thing for sure: he seems to know a lot more about managing inflation than Jim Chalmers does.
    And anyone who has taken the trouble – as Peter Smith has – to read Jim Chalmers’ recent 5713 word paper in full, certainly deserves a commendation and our sympathy. It takes real dedication to persevere through so much unadulterated, self-indulgent waffle.
    However I don’t think Jim Chalmers really wants to “decapitate” the RBA … just yet. Jim Chalmers will want Phillip Lowe to linger around a little longer so that the RBA Governor can take the hit if inflation gets out of hand or if the higher interest rates needed to reduce it lead to a recession.
    And there’s a risk that the level of interest rates needed to subdue inflation – given the fiscal restraint inaction by Labor – might possibly cause a recession. It’s also possible that – given Labor’s fiscal restraint inaction – interest rates alone won’t be enough to subdue inflation.
    Interest rates have had to rise faster and to a higher level than if Labor had taken some fiscal action to get inflation down.
    Labors’ last budget added billions to demand and that addition to demand has predominantly remained intact. It includes, for example, a good woke dollop of middle class welfare to households with joint incomes up to $500,000 that our Treasurer has doggedly retained. That just shows Labor’s had no appetite whatsoever to reduce the spending pressure from its budget to help in the inflation fight.
    Jim Chalmers has actually been claiming that Labor has been so virtuous and shown great restraint because they haven’t committed to substantially more spending than they’d committed to in the last budget or at the last election! It’s takes the hide of a rhinoceros to claim that. The last budget was only in May and there’s now a serious inflation threat!
    In that context I have a problem with Peter Smith saying this:
    “What is the RBA (and other central banks) to do? Persuade the government to be less spendthrift? Forget that one, particularly if a Labor government is in power.”
    That’s exactly what Labor should be doing: being less spendthrift. Commentators, the RBA and the opposition should all be putting pressure on Labor, at a time when inflation is threatening, to be less spendthrift.
    I’ll give just a couple of examples where Labor could start : cut the wasteful middle class welfare on childcare and housing handouts to those with joint incomes up to $500,000.
    Then have a good look at public service staffing levels. From my experience of over 20 years in senior management positions the public service is over-staffed by at least 30%. Reducing wasteful public service staffing levels would not only help take inflationary pressure off the economy it would also add to labour supply at a time like this when there’s a Labor shortage which is threatening to add further to inflation.
    Jim Chalmers’ rhinoceros hide was also in full view when he claimed that giving childcare handouts to reasonably well off people would help reduce inflation. That was quite a contortionist act to claim that. He was saying it would increase the labour participation of married women and therefore reduce labour cost pressures. Interesting virtually his only anti inflation measure involved spending more money.
    A couple of things wrong with that. Firstly reasonably well off people could already afford childcare. The cost wouldn’t be keeping them out of the workforce now.
    And the huge labour shortages in the childcare sector would mean that no new places could be provided anyway -at least in time to have any effect on the current inflation threat.
    The subsidies would simply add to the level of demand for childcare and what people could pay for it. And without new places providers could charge more, adding to inflation.

  • nilsm says:

    Thank-you again, Peter Smith, for another informative and well written article. I always look forward to your articles.

Leave a Reply