Why inflation isn't higher

4 Comments

 

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 is a trade. Consequently, central banks put asset inflation into the too hard basket and don’t let it affect their decisions on interest rates.

 

'If you print too much money in a closed system and the amount of production stays the same then it follows inevitably that prices will rise. That is the orthodoxy.'

 

There are signs that asset inflation is beginning to leak into consumer price inflation, though. As analyst Bill Blain comments the ‘last 12 years of monetary experimentation, quantitative easing, and buying back bonds and keeping interest rates artificially low’ has caused inflation in financial assets, which he believes ‘is now creeping into the real world.’ If that happens and then interest rates rise, hold on to your hats.

The second reason that money printing has not resulted in consumer price inflation is that Western financial systems are not closed. The models economists tend to use implies a closed system. If you print too much money in a closed system and the amount of production stays the same then it follows inevitably that prices will rise. That is the orthodoxy.

But these systems are a long way from closed. In the US system, for example, $US6 trillion flows across borders every day. It is how America is getting away with currently spending twice what it is taking in as tax revenue. There are so many US dollars sloshing around the world that the American government’s profligacy gets lost in the mayhem.

It is the same with the money printing and inflation. Because the money that is being created out of thin air is then moving all over the world in cross border transactions, it is not held inside the system and so does not cause consumer price inflation.

But that could easily change. If there is one truism in financial markets it is that the future will be different from the past and there may be growing pressure for inflation in tangible assets like fertile land. This will in turn cause consumer prices to go up, starting with food.

At some point there will be a price that has to be paid for such recklessness.

 

 

 

David JamesDavid James is the managing editor of personalsuperinvestor.com.au. He has a PhD in English literature and is author of the musical comedy The Bard Bites Back, which is about Shakespeare's ghost.

Main image: Reserve Bank of Australia reveal new $5 banknote (Handout/Getty Images)

 

Topic tags: David James, inflation, interest rates, stock market, global debt, economics, financial markets

 

 

submit a comment

Existing comments

Great read! You had me at "printing money with their ears pinned back" :-) Thanks for describing a complex situation in a way that can be understood by the interested layperson, prepared to work a little to 'get it'. So, the instant inflation even *begins* to rise, this unstable system with ridiculously high loop-gain will fail catastrophically? Or do the flat-eared people simply Xerox-off even more moolah to try and make it all go away... wait a moment, doesn't that drive inflation?


Richard Jupp | 13 August 2021  

“The American government’s profligacy” seems to know no limits. Already inflation is roaring back in the US, with shelter, goods and services showing the highest increase since the 1970s. The big difference between 1970 and 2021, is the enormous US debt (now $28 trillion), and the unholy alliance between Wokeness and Capitalism, two groups which loath each other, which is being called anything from an “arranged marriage” to “the Woke-Industrial Complex.” On August 5, big business threw their lot in with China. More than 30 business organizations appealed to the Biden administration to eliminate tariffs on imports from China, seen as the quickest way to reduce inflation. A deal seems likely because inflation could poison the Democratic Party’s chances in the 2022 mid-term elections. Already Biden’s open border policy could see 2 million illegal crossings this year with additional welfare benefits; his energy policy has crushed domestic drilling so he’s pleading with the Middle East to pump more oil; and he’s now begging the Taliban not to attack the US Embassy in Kabul. This will end badly.


Ross Howard | 13 August 2021  

Inflation ‘is now creeping into the real world.’ Tell that to anyone trying to pay off a $1m very ordinary house.

The correct characterisation of the present is that there is rampant inflation - in property and stocks. It's 'too hard' for economists to measure? The rest of us can see it. I know you're only reporting David, but it helps if you point out where the insanity is.

There is far too much money chasing 'assets', so they inflate. It's not hard. Blind folly in our central banks.


Geo | 16 August 2021  

Great read! You had me at "printing money with their ears pinned back" :-) Thanks for describing a complex situation in a way that can be understood by the interested layperson, prepared to work a little to 'get it'. So, the instant inflation even *begins* to rise, this unstable system with ridiculously high loop-gain will fail catastrophically? Or do the flat-eared people simply Xerox-off even more moolah to try and make it all go away... wait a moment, doesn't that drive inflation?


Richard Jupp | 17 August 2021  

Similar Articles

Homelessness is caused not by poverty but by wealth

  • John Falzon
  • 10 August 2021

When you put rising housing costs alongside stagnating wages, an alarming trend in normalising insecure work, persistent unemployment and underemployment, and statutory incomes that are going backwards in real terms, there’s good reason to be deeply worried about an increase in homelessness.

READ MORE

x

Subscribe for more stories like this.

Free sign-up