Inflation and Interest Rates

Yesterday’s decision by the Reserve Bank to raise interest rates by a quarter of 1 per cent is a direct response to re-emerging signs of inflation.

Some of us can remember the high inflation and high nominal interest rates of the 1970s and 1980s. But even if you can’t remember those years, the Commonwealth Treasurer misses no opportunity to attribute the low inflation of the last 10 years wholly and solely to the policies of the Coalition Government. The truth is that inflation was well under control before the Coalition came to office, and it has remained low more through good fortune than through sound management Government policies, in fact, often contributing to inflation.

And we should remember that the most common indicator of inflation, the Consumer Price Index (CPI), is only a partial measure averaged across all people in all capital cities. In fact, if one digs deeper into the figures, it’s easy to see that movements in one person’s cost of living may be quite different from movements in another’s. And although the luxuries of life may have fallen in price relative to the necessities of life, then it’s also true that those struggling to make ends meet have experienced higher inflation than those in more comfortable situations.

Thanks to Sean Leahy.

As in other industrialised countries, inflation peaked in Australia in the early 1970s and then generally fell bottoming out in the early 1990s. Official policy in Australia is to try to contain inflation within a ‘comfort zone’ of between 2 and 3 per cent. Last week’s figure of 3.0 per cent, was nudging the top of that zone and was probably the trigger for the Reserve Bank’s decision.

The fall in inflation from 1975 to 1990 can be attributed to many factors:

– tariff reductions most effectively in the previously highly protected industries of clothing, footwear and motor vehicles. We now have very few high tariffs left to reduce the only significant one being a 17.5 per cent duty on clothing, which is trivial compared with effective tariffs of 100 per cent or more, in previous times;

– technologies particularly the growth of information and communications technologies;

– the People’s Republic of China’s mobilisation of its workforce in consumer goods industries, particularly clothing, appliances and electronics, combined with the PRC’s deliberate policy of maintaining a low exchange rate. (There are early signs that this exchange rate may rise);

– Australia ‘s high interest rates compared to other industrial countries, driven in part by the need to suppress a housing bubble (a bubble resulting largely from badly structured tax policies by the Keating and Howard Governments). High interest rates sustain a high exchange rate, which keeps down the price of imports. Once our commodity boom ends, and as other countries raise their interest rates, our exchange rate will inevitably fall;

– competition and other microeconomic reform, initiated under the Hawke and Keating Governments and continued into the early days of the Coalition Government. But the Government is now timid of further reform its Industrial Relations package needs to be seen in the context of an ideological hostility towards organised labour, rather than any genuine program of reform.

In short, the good fortune which has kept inflation low has largely been exhausted. Apart from the ongoing benefits of new technologies, there are few gains to be made. Worse, however, prices have been contained only on some items, masking strong price rises on others.

The table below illustrates 16 years of price changes in some of the many items surveyed in the CPI surveys. The table is selective there are 126 items in the CPI survey and it does not include items (such as food) which have moved in line with the average 52 per cent rise in the CPI over this period.

Selected price movements: 1989-90 to March 2006
Education	160%
Insurance	156%
Hospital and medical services	139%
Child care	123%
Dental services	120%
Urban transport fares	112%
Automotive fuel	105%
Beer	88%
Gas and other household fuels	83%
Pharmaceuticals	64%
Electricity	56%
All items (Average)	52%
Overseas travel and accommodation	26%
Major household appliances	9%
Clothing and footwear	8%
Telecommunications	7%
New motor vehicles	-1%
Toys, games and hobbies	-4%
Small household appliances	-7%
Audio, visual and computing equipment	-73%
Source: ABS CPI 6401.0 March 2006

This table illustrates two general points about price movements since 1989-90:

– the strongest rises have been in some of the necessities of life. The only broad ‘necessity’ group for which real prices have fallen (ie prices have risen more slowly than the average) is clothing;

– many of the highest price rises have been in items influenced by Government policy.

For example, we may be surprised that, while there has been so much publicity given lately to price rises in automotive fuel, its price has risen more slowly over the past 16 years than many other items, including urban transport fares.

Is this obsession with fuel also distracting us from price rises in health, education, child care and insurance? These have all been subject to cost-shifting policies by Commonwealth and State governments. The cost of child care, in particular, has risen by 12 per cent over the last 12 months. The Commonwealth should have learned from private health insurance subsidies that if a government spends money on open-ended subsidies rather than on more carefully managed direct service provision, the result is inflation. But they have repeated the mistake with child care, to the benefit of child care corporations.

Notably, the CPI has only recently included the cost of financial services (2005) and houses (1998) which saw their highest rises before they were captured in the index.

And the CPI only covers the eight capital cities. Apart from housing, prices in the bush are generally higher because of higher transport costs and less competition among suppliers.

This is not to suggest that the Bureau of Statistics is concealing anything from the public. The data and the methodology by which it is collected and analysed are all openly available. (For the complete bulletin, listing all 126 items, see here). And because the Bureau is not under the direct control of Executive Government, it has not suffered from the politicisation of other agencies.

The problem lies with politicians who glibly quote headline figures and blame our ills on oil producers, and with lazy journalists who fail to delve into available data.

We can sum up price movements by observing that over the past 16 years you’ve done pretty well if you live in the city and don’t commute very far, and if you holiday overseas, buy a new outfit of clothes every couple of months, and have spent your spare cash on a new car, a plasma TV and a Bang & Olufsen hi-fi system.

If, however, you are less privileged a ‘battler’ bringing up a family life has not been so easy, even if your income has kept pace with the CPI. Higher school fees, health costs, road tolls, and utility payments are the price you are paying for government cost-shifting and privatisation.

Your inflation is already well over 3 per cent, and has been for years.

Like Winston Smith in George Orwell’s Nineteen Eighty Four, whose poverty is mocked by Big Brother’s assurances that Ingsoc is achieving wondrous production figures, the battlers are expected to believe that our governments, through their economic prowess, have inflation licked.

They haven’t.

New Matilda