The high cost of Lowe inflation

Australia is the world’s largest exporter of liquified natural gas and Saudi Arabia is the world’s largest exporter of oil, but, while Australians struggle with the soaring price of energy, the Saudis’ inflation rate of 2.8 per cent is low enough to make even Reserve Bank of Australia governor Philip Lowe smile. Government policies matter, and some policies are better at controlling inflation than others.

While the Saudis protect their citizens from soaring energy prices, in Australia we protect the fossil-fuel companies from paying tax. Australia exports more LNG than Qatar, but Qatar collects 20 times more tax from its gas exports than we do. Its inflation was 3.7 per cent over the past 12 months. Imagine if we collected more tax from the gas industry and made childcare free. Again, government policies matter.

Economists around the world debate everything about inflation, from whether it truly is a big problem to how best to measure and control it. But here in Australia, until recently at least, the RBA, Treasury and most of our financial press had decided there was no need for such debate. Even though none of our key economic advisory bodies saw the current surge in prices and profits coming, they are all confident their old tools are the best way to fix this new form of inflation caused by Covid supply shocks, Russia’s invasion of Ukraine and soaring profits. 

Philip Lowe was so confident in his model of how inflation works that in September 2021 he said you couldn’t have persistently high inflation without consistently high wage increases. A few months earlier, in February, he said he wouldn’t increase interest rates until 2024. As history records, he was completely unable to predict his own decision-making and, despite real wages falling faster than ever before, he started increasing interest rates faster than ever before. Whoops.

The RBA governor isn’t just bad at predicting his own behaviour, he doesn’t even seem able to grasp what’s happening in the economy right now. Even though the profit share of GDP is at a record high, and even though the non-mining profit share of GDP is 1.4 percentage points higher than it was in 2019 (equivalent to $31 billion in extra profits), Lowe recently said “the profit share outside resources hasn’t changed”.

There are none so blind as those who will not see.

The RBA’s model of how the economy works assumes it is wage growth, not the price-setting power of companies, that drives inflation. To our central bankers, profits are simply a “residual” that is left over after “market forces” set prices and greedy workers set wages. Of course, like all models, it’s only as good as its assumptions.

A year ago, some colleagues from The Australia Institute and I published research showing that rising profits, not rising wages, seemed to be driving the rising inflation that Lowe hadn’t seen coming. The method we used was developed by the radical lefties at the European Central Bank and the results for Australia were quite clear: the RBA’s focus on wage growth was entirely misplaced. But, as some insist Gandhi said, “First they ignore you, then they laugh at you, then they fight you, and then you win.”

The initial reaction to our research was muted at best. It attracted good media attention and interest from other researchers, but not one of the RBA’s hundred staff reached out to discuss our results and their implications. Then three days after the release of the paper, the Australian Financial Review ran a story taking an egg beater to the opinion of UNSW Sydney’s Professor Richard Holden, the president of the Academy of the Social Sciences in Australia, whose description of our research as “silly” made its front-page headline. Clearly the RBA and its allies couldn’t keep ignoring our evidence, so they decided it was time to start laughing at it. There was more to come.

In April, my colleagues Jim Stanford and Greg Jericho from the institute’s Centre for Future Work released more evidence of the role of profits. This time, unnamed bureaucrats at Treasury and the RBA, who had been beavering away writing critiques of our research, responded. The Treasury brief found no computational errors in our research but described the method as “flawed”. The RBA brief was similarly dismissive.

But, for voters at least, rising interest rates are no laughing matter, and mounting evidence of rapid growth in profits meant that simply laughing at those who thought there might be a link between high prices and high profits wasn’t cutting the overpriced mustard. It was clearly time to stop laughing and start fighting.

As luck would have it, the AFR decided to make a freedom of information request to Treasury and the RBA seeking any criticism of the work done by the Centre for Future Work. And, as even more luck would have it, both the RBA and Treasury dealt with those FOI requests in a timely and comprehensive manner. (I suppose it’s reassuring to know that not everyone’s FOI requests are met with major delays or redactions.)

The FOI documents from RBA and Treasury led to yet another AFR front-page attack on our research, which was described as “flawed” and “misleading”, and carried a demand from Professor Holden that The Australia Institute “admit their mistake and retract their so-called analysis”.

Poor Philip Lowe just can’t take a trick. Just two weeks after the president of the peak body for Australia’s economists demanded we retract our research, the OECD, now led by former Liberal finance minister Mathias Cormann, entered the fight with a decisive blow. The Sydney Morning Herald reported on an OECD analysis: “Corporate profits contributed far more to Australia’s rise in inflation through the past year than from wages and other employee costs, according to international research that challenges the official view of the Reserve Bank and federal Treasury.” Nobody has yet called the OECD silly, nor have any critiques of its work yet been leaked to any newspapers.

There is no science behind Australia’s obsession with keeping inflation between 2 and 3 per cent – it’s just an arbitrary target range formalised in Peter Costello’s first Statement on the Conduct of Monetary Policy, in 1996. It has remained unchanged ever since. Some countries have no targets, some countries have different targets, but despite all that has been written about inflation in Australia, there’s barely a word about whether the target might be the problem.

Likewise, the RBA’s obsession with relying so heavily on interest rates to control inflation and blaming greedy workers for causing inflation dates back to the 1970s. This approach doesn’t just predate “buy now, pay later” services and internet banking, it predates the internet. And its obsession with workers’ bargaining power was formed when 51 per cent of workers were in unions. In Australia today, that figure is now 12.5 per cent.

This time last year, The Australia Institute wasn’t just showing that profits were driving inflation, we were proposing new and better ways to fix it. As is now widely accepted, beyond the RBA at least, competition policy needs to be strengthened to curb the price-setting power of some of our biggest retailers. The chair of AGL, Australia’s largest electricity generator, recently said that government-imposed price caps on coal had helped keep electricity prices down. And even the treasurer accepted our argument that, used creatively, government spending could be used to lower inflation, rather than increase it: Jim Chalmers said that new spending measures in the budget were “carefully calibrated to alleviate inflationary pressures, not add to them”.

Put simply, with a bit more creative thinking, and a bit less mindless critique of external experts, Treasury and the RBA could go a lot further and faster in their goal of reducing inflation without imposing more pain on mortgagees or risking recession. Indeed, those worrying about inflation might even ask themselves whether the government’s planned $20 billion per year in “Stage 3” tax cuts due to start next July still make sense. If that amount was instead spent making childcare free and university degrees cheaper, then the consumer price index would fall, female labour force participation would rise, productivity would grow in the medium term and there would be less inequity. Or we could just jack up interest rates again because that’s what we usually do.

Government policies matter, and good policy adapts to changes in technology, the tastes and preferences of citizens, and world events. Sticking to a 2 to 3 per cent inflation target, relying heavily on interest rate policy to meet it, and blaming workers for wanting higher wages when the policy fails makes life easy for those designing monetary policy but brutally hard for those with mortgages. And it’s simply not very effective.

Just like the companies that say they have no choice but to increase their prices and profits, our major policy institutions like to pretend we have no choice but to lift mortgage rates and cut income taxes for the rich. The OECD provided a timely reminder of how narrow and ossified our key economic policy institutions have become. We will likely have a new governor of the RBA by the end of the year, but unless we have a new approach to debating and designing macroeconomic policy, I fear not much will change.

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