What’s driving inflation and what does it mean for monetary policy?

The idea that the surge in inflation was caused by rising profits has resurfaced with the appointment of a new RBA Governor, Michele Bullock. Sally McManus of the ACTU and Richard Dennis of the Australia Institute have suggested that high interest rates are ineffective in suppressing high inflation.

To be clear, high inflation is a problem. Anyone who doubts its corrosive impact on economic activity needs to remember that the 1970s was not just about disco.

Lower interest rates now would result in higher, not lower, inflation and so ultimately higher rates.

The Australia Institute recently published two pieces of work suggesting that profit growth was responsible for around two-thirds of inflation, drawing on methodology also used by the ECB and OECD.

But that idea has been analytically shown to be flawed in work by the Reserve Bank of Australia, Federal Treasury and numerous academic experts.

The arguments against profits driving inflation are simple.

While profits have increased in Australia, that’s only been for the resources sector. Both aggregate National Accounts data and company level data show that non-mining profits have not increased. You can always cite one company with rising profits, but the plural of anecdotes is data.

The analysis pointing a guilty finger at profits uses production prices (the GDP deflator) rather than consumption prices (the CPI). There is a wedge between those because Australia produces a lot more commodities than we consume.

So how should we think about rising mining profits and the appropriate monetary policy response?

Energy prices are set in the global market. Oil, coal and gas can all be shipped internationally. As a result, their prices are broadly similar in different countries.

Consider a country with no resource sector which then must import all its energy, such as Singapore. The surge in energy prices from Russia’s invasion of Ukraine increased domestic inflation because of the direct and indirect impact of higher prices for oil and gas. 

The impact on firms’ profits depends on firms’ ability to pass through higher input costs to their selling prices. In competitive industries, consumer prices increase to cover firms’ additional input costs leaving profits unchanged.

Now compare to Australia where there is a large resource sector. Energy prices are still determined in the global market. While we export energy commodities, we also import some energy commodities, such as petrol. Over 3/4 of Australia’s resource output is exported. So, in effect we can think of the commodity sector as being separated from the rest of the economy.

Higher energy prices deliver higher profits in the commodity sector in Australia. But just as it is in Singapore, higher energy prices in Australia contribute to higher consumer prices. When you compare Australia with Singapore, where there is no resources sector, we can see higher resource profits did not cause inflation.

Even if Australia had no resources sector, we would have had a pickup in inflation anyway. In other words, just because profits and prices both went up does not mean higher profits caused inflation. Correlation does not imply causation.

What does it mean for interest rates whether inflation’s smoking gun is pointing at profits or other factors?

Pretty much nothing.

For a moment, suppose that firms did have the ability to suddenly increase profits by raising their prices. Presumably they hadn’t been forsaking higher profits earlier, so something increased their pricing power, a likely candidate could be stronger demand.

In any case, what should monetary policy do? The RBA has a mandate to keep inflation low and stable. Choosing not to raise interest rates to soften demand would mean that inflation remains high and inflation expectations rise. Understandably wage growth would increase but it would also ingrain high inflation in the economy, suppress economic growth, and push unemployment higher, just as it did in the 1970s.

We give central banks independence and the responsibility for maintaining low and stable inflation because experience has taught us this works best. Internationally, the 1970s and 1980s showed that there are conflicts in politicians having responsibility for demand management policies to constrain inflation. 

Their incentives related to the electoral cycle clash with using consistent policies that impact demand and inflation with a lag. Monetary policy has been successful in maintaining low inflation for the past three decades and it is already showing signs of reducing inflation this time.

None of this means we should be sanguine about any lack of competition. A host of experts (including MP Andrew Leigh, the current and previous chairs of the ACCC, academics and researchers at e61) have highlighted that a lack of competition can weaken productivity and output. Policies to promote competition are worth pursuing for a host of reasons, but they aren’t going to solve our current inflation problem.