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3 misconceptions you have about inflation

After five years of fluctuating around the two per cent mark, the inflation rate in Australia has jumped considerably in the past 12 months.

Measured quarterly, inflation is based on the change in the consumer price index; it hit 3.8 per cent in July last year and is currently sitting at 3.5 per cent – the highest point since 2014.

And it is not just limited to Australia.

New Zealand’s inflation is increasing at rates not seen for three decades, while in the US inflation is at a 40-year high.


Interest rate concerns

Rising inflation is stimulating speculation that the Reserve Bank of Australia (RBA) will increase interest rates.

The RBA, like most national financial bodies, aims to keep inflation between two per cent and three per cent on average, and the interest rate, also known as the cash rate, is its primary mechanism for doing so.

Because inflation has been consistently within that mark for several years, the RBA has kept our interest rate at 0.1 per cent since late 2020.

It has never been lower.

But with inflation rising across the globe, it appears we are on the precipice of our first interest rate rise since 2010.

Philip Lowe, governor of the RBA, confirmed as much when speaking after the most recent rate decision in early April.

“Our policies during the pandemic have supported progress towards the objectives of full employment and inflation consistent with the target,” he said.

“We have wanted to see actual evidence that inflation is sustainably within the two to three per cent target range before we increases interest rates.

“Inflation has picked up and a further increase is expected, but growth in labour costs has been below rates that are likely to be consistent with inflation being sustainably at target.”


But you shouldn’t be too fearful

Words and phrases such as inflation and interest rates tend to strike fear into people, but both concepts are a little more complex than they appear on the surface.

In a recent statement from global investment firm Western Asset, economist Michael Bazdarich said many consumers hold misconceptions about inflation that cause overreactions amidst news headlines.

“With inflation reaching levels not seen in 40 years, rising prices are demanding attention from investors and consumers alike,” he said.

“However, the underlying forces responsible for rising inflation may not be widely understood.

“Any run of higher prices caused by supply disruptions or even overly expansive fiscal policy should soon run its course, and I see nothing different in the COVID-19 era, other than the added complexities introduced by the related economic shutdown.

“I believe the recent price burst will die out of its own momentum, or lack thereof.”


Misconception one: money supply and wage growth lead to higher inflation

Bazdarich said the belief that an increase in money supply and faster wage growth leads to high inflation are both misconceptions.

“Our approach to inflation is first and foremost a monetary one,” he said.

“The process of sustained price increases that can push interest rates higher can only be driven by overly expansive monetary policy, which creates the purchasing power to sustain higher and rising prices.

“Without that creation of purchasing power by the monetary authority, any run of higher prices caused by supply disruptions or even overly expansive fiscal policy will soon run its course.

“Meanwhile, rapid wage growth is a consequence of inflation, not a cause of it. While we often hear references to ‘wage-push’ inflation, there is no evidence for increases in wages autonomously driving higher inflation.”


Misconception two: supply chain disruptions will cause sustained inflation

From meat to fruit, hand sanitiser and, of course, toilet paper, it has been clear that supply chains have been impacted thanks to the pandemic.

Bazdarich, however, said that supply chain disruptions are unlikely to cause sustained inflation over a longer-term.

“There is no denying the fact that a reduction in supply—opposite stable demand—will result in an increase in prices,” he said.

“Indeed, as stated earlier, the increase in goods prices occurring over the last four months can be attributed to the supply-chain disruptions and port congestion the US experienced in 2021. Economic analysis is just as clear, however, that those supply reductions lead to a decline in quantities produced.

“After all, under this analysis, increases in prices are necessary to bring demand into line with the reduced supply.

“The point is that as supply disruptions ease, supply will be increasing, and that will work to stem and then reverse increases in prices. Nominal demand is growing no faster than it did pre-COVID-19.

“Without an acceleration in demand growth and with a normalisation of supply and supply growth, goods prices must moderate, even decline.”


Misconception three: higher commodity prices drive inflation

As a country that benefits greatly from a safe, robust and productive mining sector, higher prices for commodities like iron ore, copper and gold have been good for many Australian producers.

However, Bazdarich said this is not necessarily linked to inflation, although the two are often interlinked.

“Commodity prices always rise early in an economic expansion, just as they always decline during recessions,” he said.

“Falling commodity prices during recessions do not drive deflations, and rising commodity prices during expansions are not necessarily a sign of inflation.

“Most of them have indeed experienced increases over the last two years. Most of them also saw increases following the end of the GFC [global finance crisis].

“In fact, most commodity prices are no higher now than they were 12 years ago at the outset of expansion then.

“The markets that are seeing higher prices now than in 2010 are the very markets where supply-chain disruptions are at work,” he said.


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