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Why inflation isn't higher

  • 12 August 2021
The biggest mystery of the financial markets is why, when the monetary authorities have been printing money with their ears pinned back, is inflation for the most part not a problem? What happens with inflation is crucial to the short-term survival of the whole system. Global debt, which is running at well over 300 per cent of global GDP, is only sustainable because interest rates are exceptionally low (the base rate in Australia is only 0.1 per cent). And interest rates are low because inflation is not a problem.

The orthodoxy followed by central banks is that if inflation rises beyond a certain level, then interest rates must also rise to reduce the supply of money in the system. Central banks no longer have any control over the quantity of money, so the only lever available to them is the cost of money, or interest rates. As we will see, that orthodoxy is about as relevant to the modern financial world as the horse and cart is to Grand Prix racing, but it is nevertheless what economists are taught at university and so that is what they will do.

Should inflation, and then interest rates, rise a significant portion of the debt would become unserviceable, which would put the banks under pressure. So far, however, inflation, as measured in the Consumer Price Index (CPI), has stayed quiescent. There has been no reason to take the risky step of raising rates, which in Australia would imperil our outrageously indebted housing market.

According to conventional economics, it should not be this way. Since the covid crisis, most central banks have been effectively printing money in a process called Quantitative Easing, whereby they buy back government debt, and sometimes corporate debt and put it on their balance sheets. With so much more money being created it should mean that inflation soars, but it is not. Why?

Two reasons suggest themselves. The first is that the extra money has not gone into spending on the things that are measured in the CPI such as: food, transport costs, clothes and rent. Instead, it has largely poured into assets such as housing and shares.

Asset inflation is not something that central banks can measure or analyse easily. Unlike the things included in the CPI, which are constantly being bought and sold and are therefore easy to track, asset transactions are lumpy and irregular and the value is only realised when there