The RBA is making confusion about inflation and the cost of living even worse

There’s a paradox about the way we respond to threats to the cost of living.

On one hand, governments put in place subsidies for things such as rent and electricity, as the federal government did in this year’s budget.

On the other hand, we get told these subsidies are inflationary because they put more free cash in the hands of consumers.

At the same time, when the cost of living climbs enough to push inflation beyond the Reserve Bank’s target, the bank pushes up interest rates in an attempt to drive measured inflation down.

For mortgage holders, this often pushes up payments. which aren’t included in the standard measure of inflation but nevertheless add to their cost of living.

By themselves, higher prices aren’t a problem

Although we often talk about the cost of living as a problem, by itself it shouldn’t bother us much.

The cost of living, as measured by the amount needed to meet basic needs, has been climbing steadily for at least a century.

In the famous Harvester judgment of 1907, Justice Henry Higgins determined that a “living wage” for a family of five was 42 shillings ($4.20) per week.

So much has the cost of living climbed that these days that can barely buy a cup of coffee.

A loaf of bread costs four pennies then, and these days costs 100 times as much.

Yet no one doubts that the typical family is better off today even though the cost of living has climbed.

The reason, of course, is that incomes have climbed faster than prices for most of the past century.

Average weekly ordinary time earnings are now nearly $2,000 a week, 500 times higher than in 1907.

What matters is not prices, but the purchasing power of our disposable incomes (which are incomes after the payment of taxes, interest and unavoidable costs).

Just recently, and unusually, wage growth has been lagging behind price growth.

In 2022, the year in which inflation peaked, consumer prices climbed 7.8% while wages grew 3.3%.

The 2022 increase in prices wasn’t at all extreme by historical standards.

Prices climbed faster in the 1970s and 1980s without producing a “cost of living crisis”.

But back then, during much of the 1970s and 1980s, wages were indexed to prices, meaning they kept pace.

As a result, increases in the cost of living didn’t worry us as much.

Sharp interest rate increases are a problem

The response of the Reserve Bank and other central banks to the inflation shock of 2022 was to rapidly and repeatedly lift the interest rates they influence, the so-called cash rate in Australia’s case, in order to drive inflation back to target.

It is important to observe that no theoretical rationale for Australia’s inflation target has ever been put forward.

Both the idea of targeting consumer price inflation and the choice of the 2–3% target band are arbitrary.

They were inherited from the very different circumstances of the early 1990s and the judgment call of a right-wing New Zealand finance minister.

The recent review of the Reserve Bank acknowledged the challenges to this orthodoxy but didn’t consider them.

A more fundamental problem, which hasn’t been properly analysed, is the relationship between high rates and the purchasing power of disposable incomes.

Higher rates benefit some, hurt others

Interest payments are a deduction from disposable income for households with mortgage debt (mostly, but not exclusively, young) and a source of income for those with net financial wealth (mostly, but not exclusively, old).

The result is a largely random redistribution of the effects of increasing interest rates.

It’s perceived by the losers as an increase in the cost of living, and by the winners as a windfall gain, enabling some luxury spending.

I made this point about the limitations of using interest rates to contain inflation at a Reserve Bank conference in the late 1990s, but it had little impact at the time.

Since interest rates remained largely stable around a slowly declining trend for the following two decades, the point was mostly of academic interest.

Until now.

The increase of about four percentage points in the Reserve Bank’s cash rate from 2022 is the first really large increase since the inflation target was adopted in the early 1990s.

We are now seeing the consequences of using interest rates to target inflation, even if they are poorly understood.

Fitting in with familiar narratives, the distributional consequences are framed in terms of intergenerational conflicts (Boomers versus Millennials) rather than the product of misconceived economic policy.

If sharp increases in interest rates aren’t the right tool to control inflation, what is?

The experience of the 1980s provides an idea.

The best idea is to avoid income shocks

Rather than seeking a rapid return of inflation to an arbitrary target band, we should instead focus on avoiding large income shocks while bringing about a gradual decline in inflation.

That would mean indexing wages to prices, and avoiding sharp shocks like the interest rate hikes in the late 1980s that gave us the “recession we had to have”.

That’s unlikely to happen soon.

In the meantime, it’s a good idea to try to avoid the traps inherent in talking about the “cost of living”, and be aware that in a world in which the actual cost of living includes interest rates, sharp increases in rates do little for many who are finding it hard to keep up.

Guest author is John Quiggin, Professor, School of Economics, The University of Queensland

This article is republished from The Conversation under a Creative Commons license. Read the original article here.