Memo to RBA: If wages growth isn't the problem, what is?

 I can’t help wondering if the Reserve Bank isn’t misreading the economy. And it seems I’m not alone.

When you’re seeking to manage the economy through its ups and downs, it’s critically important to diagnose its problems correctly. If you’ve misread the symptoms, you can make things worse rather than better. Or, for instance, you can single out citizens who had the temerity to borrow heavily to buy their home and subject them to needless punishment.

Last week, several things made me start wondering if the Reserve needs a rethink. The first was a paper by America’s highly regarded Brookings Institution, that I should have got onto in August.

The world’s central banks – including ours – have concluded that this unexpected burst of inflation is explained partly by temporary disruption to the supply of goods caused by the pandemic (and Russia’s attack on Ukraine), and partly by excessive demand following the authorities’ excessive economic stimulus to counter the lockdowns.

Sorry, not true says the Brookings study, which looked at new data.

“The vast majority of the COVID-19 inflation surge is accounted for by supply-linked factors, especially a rise in company [profit] margins that followed severe delivery delays at the height of the pandemic. Demand-linked factors, notably indicators of labour market overheating, play almost no role.

“As a result, the argument that policy stimulus was excessive is weak,” the study says. And, since company profit margins have yet to return to their previous level, this suggests the inflation rate has yet to fall as the effects of the pandemic continue to unwind. If so, the US Federal Reserve may have overtightened.

Now, all that refers to the US economy and may not apply to ours. May not, but I doubt it.

Despite four successive quarters in which the economy’s rate of growth in “aggregate demand” has been very weak, our Reserve is delaying a reduction in interest rates because, it says, the level of demand is still higher than the level of supply. If so, the rate of inflation may not keep falling, or may even start rising.

How does the Reserve know the level of supply is too low? Mainly by looking at the measure of idle capacity in the jobs market – aka the rate of unemployment.

So, when we saw the figures for October last week, and they showed unemployment still stuck at an exceptionally low 4.1 per cent, no higher than it was in January, it wasn’t surprising that many concluded the Reserve wasn’t likely to start cutting the official interest rate until May next year.

But hang on. One good measure of the job market’s ability to supply more labour as required is the “participation rate” – the proportion of the working-age population willing to participate in the paid labour force by either having a job or actively seeking one.

Now, the econocrats have been predicting that the ageing of the population would cause the “part rate” to start falling for at least the past 20 years. But in that time, it has kept going up rather than down, and is now higher than ever. Last week’s figures show it’s risen by a strong 0.5 percentage points to 67.2 per cent over just the past year.

So where’s the evidence the economy’s reached the end of its capacity to supply more workers?

My guess is that all the Reserve’s unaccustomed talk about the level of supply being too low relative to demand is just a way for it to avoid admitting that its judgment about when to start cutting interest rates is still – as it has been for all macroeconomists for the past 40 years – heavily reliant on its calculation of the present NAIRU: the “non-accelerating-inflation rate of unemployment”, which is the lowest the unemployment rate can fall before shortages of labour cause wage inflation to start going back up.

I think the Reserve’s reluctance to cut is driven by its (undisclosed) calculation that the NAIRU is well above 4.1 per cent. But earlier this month, Treasury secretary Dr Steven Kennedy told a parliamentary committee that, though such calculations are “uncertain”, Treasury estimates that the NAIRU is “around 4.25 per cent, close to the current rate of unemployment”.

Another thing we learnt last week was that a key measure of the rate at which wages are rising, the wage price index, rose by 0.8 per cent during the September quarter, causing the annual rate to fall from 4.1 per cent to 3.5 per cent.

According to Adam Boyton and other economists at the ANZ Bank, this caused the six-month annualised rate of wages growth to be unchanged at 3.2 per cent. “Wages growth has slowed across awards, enterprise bargaining agreements and individual agreements, pointing to a broad-based slowdown,” they said.

This – combined with the lack of increase in the rate of unemployment over the past year, and allowing for the delay before what’s happening to unemployment affects wage rates – has led these economists to conclude the NAIRU is closer to 3.75 per cent.

Finally, Westpac chief economist Dr Luci Ellis noted last week that another measure of wages pressure, the cost of labour per unit (which takes account of changes in the productivity of workers), has fallen from an annualised rate of 7 per cent to 3.5 per cent in just the six months to September.

She said that even if the annual improvement in the productivity of labour averages a touch below 1 per cent, which would be worse than our recent performance, annual wages growth averaging 3.2 per cent – as it has for the past three quarters – is “well and truly consistent with inflation averaging 2.5 per cent or below”.

Get what all this says? Ever since the Reserve began raising interest rates in May 2022, it has worried about the possibility of excessive growth in wages keeping inflation above the Reserve’s target zone. In all that time, and particularly now, it’s shown absolutely no sign of doing so. Neither shortages of labour nor the (much reduced) power of the unions has caused a problem.

The Reserve needs to lose its hang-up about wages and think harder about the need to ease the pain on innocent bystanders.

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Why the big parties' professed housing fixes won't work

I’m sorry to tell you, but it’s becoming increasingly likely that next year’s federal election campaign will feature a fight over which side has the better policies to end the housing crisis. Why is that bad news? Because neither of the major parties’ proffered solutions would do much good.

The Albanese government wants to introduce two schemes – Help to Buy and Build to Rent – but these are being blocked in the Senate by the opposition and the Greens. If they’re not passed, Labor will go to the election claiming it has the policies that could fix the high cost of housing, but is being stopped by its evil, anti-housing opponents.

The Liberals claim Labor’s schemes are no good, but that their own proposal, Super for Housing, would do the trick. As for the Greens, they’re blocking Labor’s schemes because, they say, they’re too small to make any difference, and Labor needs to agree to their proposals to make that difference. What proposals? To end negative gearing, spend a lot more on building social housing, and limit how much rents can be increased in any year.

The Greens are selling themselves as the party for renters. This is no bad thing. The two big parties have never worried much about renters, even though they make up about a third of households.

The real problem is that the big parties’ schemes don’t stand up to close examination. They’re designed to look bigger and more helpful than they really are.

The term housing “crisis” is misleading. Both sides of politics have sat back for decades, happily watching house prices rise faster than household incomes.

When you go back to basics, the cause of rising house prices is that the demand for properties is growing faster than the supply of them. The only policies that slow the rise in prices are those that either add to the supply of homes or reduce the demand for them.

So when governments pretend to help first-home buyers with grants or reduced stamp duty, they’re neither adding to supply nor reducing demand. They’re just making it easier for some people to pay the high price. Get it? They’re actually helping keep the price high. And if they help enough buyers, they’re probably pushing prices a bit higher.

This is what’s wrong with both Labor’s Help to Buy scheme and the Libs’ Super for Housing scheme. Labor’s scheme would involve the government giving eligible homebuyers up to 40 per cent of the home’s purchase price, but retaining ownership of the same proportion of the home’s value.

Whenever you sold the house, you’d have to buy out the government’s share, which by then would be a much higher amount than you were originally given. This is a condition that hasn’t appealed to many people when some of the states have offered similar schemes. There haven’t been many takers.

Labor’s scheme would be offered to a maximum of 10,000 buyers a year. This may sound a lot, but in an economy of 27 million people, it ain’t.

The deeper problem, however, is that, as with previous straight-out grants to first-home buyers, it doesn’t reduce the price of homes but, rather, makes them a bit easier for a few lucky people to afford. By doing so, it actually adds to the demand for homes, so putting upward pressure on prices.

The Libs’ objection, however, is that Labor’s scheme smacks of socialism. Their rival plan, Super for Homes, would allow eligible buyers to add to their home deposit (and thus to the amount they could borrow), by withdrawing up to $50,000 from their superannuation savings, provided it was no more than 40 per cent of their super balance.

One objection to this is that it wouldn’t do much to help younger homebuyers, since they wouldn’t have accrued much super. But, again, the more serious criticism is that the scheme would actually add to the demand for homes and so help push prices higher.

By contrast, Labor’s other scheme, Build to Rent, would offer special tax concessions to those big concerns that built new blocks of apartments and rented them out. So it would – in principle, at least – help by adding a bit to the supply of homes.

And, to be fair to the government, its already-implemented deal with the state governments, where it’s giving them big bucks to facilitate the building of 1.2 million new homes over five years, would – in principle – add to the supply of homes, particularly higher-density housing in the parts of capital cities where people most want to live.

Why will we be increasing the supply of homes only “in principle”? Because, right now, the nation’s home building industry can’t expand without more tradespeople. It’s short of workers because a lot of them have gone off to work on the states’ big infrastructure projects, but also because for years the industry has been saving money by not training enough apprentices.

When you’ve allowed homes to become ever-harder to afford over many decades, a few showy schemes won’t suddenly fix the problem.

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All the reasons house prices will keep rising until we wake up

Contrary to popular opinion, the cost-of-living crisis will pass. But the housing crisis will go on worsening unless politicians – federal, state and local – try a mighty lot harder than they have been.

The cost of home ownership took off – that is, began rising faster than household incomes – about the time I became a journo 50 years ago, and is still going. Even the (unlikely) achievement of Anthony Albanese’s target of building 1.2 million new homes by 2029 probably wouldn’t do more than slow the rate of worsening affordability for a while.

You’d think there must be some kind of limit to how much harder it becomes to afford a home of your own, but considering how long it’s been running, it’s difficult to see just how it will come to an end.

It’s the advent of the Bank of Mum and Dad that’s making the rise in prices seem self-sustaining. Housing prices keep rising, but this makes the existing home owners wealthier, giving them greater wherewithal to help their kids afford the higher prices, which keeps those prices rising, rather than falling back to a level young people could afford without a special leg-up.

Small problem: we end up with a country divided between those born into the wealthy, home-owning class and those born into the class where generation after generation has never been able to afford to own the home they live in. Is that the Australia we want to live in?

How on earth did we allow housing prices to rise faster than household incomes for the past five decades, with little reason to hope this gap won’t get ever wider?

By allowing the slow but steady decline in the rate of home ownership – which began in the mid-1970s – to be a problem we’d worry about later. Or worse, to be a problem the politicians only pretended to care about.

I call this the Howard Effect. John Howard takes the credit because he’s the polly who most clearly hinted at the political class’s true lack of concern about declining home ownership.

He was always repeating the line that he had yet to meet a home owner who thought rising house prices were a bad thing. Get it? The number of happy home-owning voters far exceeded the number of unhappy young couples unable to join the club.

But the rise of the Bank of Mum and Dad has changed this calculus. It’s proof of home owners’ dawning realisation that rising house prices are a two-edged sword. They’re not a problem only if you don’t give a crap about your kids.

It’s probably housing’s big part in the cost-of-living crisis that’s finally broken the dam of politicians’ disinterest in housing affordability. What is of lasting significance about the Albanese government’s efforts to speed up the rate of home-building is its shift to seeing blockage on the supply side of the housing market as the key to progress.

Until now, those seeking to do something about the decline in home ownership have focused on the way special tax breaks and pension exemptions add unhelpfully to the demand for housing.

But the misguided notion that its plan to reform negative gearing and the capital gains tax discount played a significant part in Labor’s loss of the 2019 federal election put paid to demand-side solutions.

The great strength of Albanese’s plan is its focus on reforming local government planning and zoning restrictions on the supply of medium and high-density housing in our capital cities.

Tax and pension problems are the responsibility of the feds. Planning and zoning restrictions are the responsibility of the states. As ever, the only way for nationwide state-level problems to be fixed is for the feds to take the lead. And, as ever, the only way for the feds to get the states to make changes is to flash the federal chequebook.

The state governments – NSW in particular – are making genuine efforts to overcome the long-standing NIMBY resistance to higher-density housing.

Great. But if you think fixing the density problem will stop housing prices rising faster than household incomes, you’re deluding yourself. Just as fixing negative gearing wasn’t a magic answer, nor is fixing density.

No problem as big and long-lasting as declining home ownership could be anything other than multi-faceted. Yes, we need to fix the supply side. But yes, we need to fix the demand side as well. And there’s more to the supply side than density, just as there’s more to the demand side than negative gearing.

Last week’s report of its Review of Housing Supply Challenges, by the NSW Productivity Commission, should be read by people in all states.

The report says local councils should lift their game in reducing the inordinate delays in accepting development approvals and in reducing unreasonable demands on builders.

I think government agencies are monopolies and, like all monopolies, they rarely resist the temptation to put their own convenience ahead of their customers’ needs.

As federal Treasury’s sermon on the housing challenge in this year’s budget papers also made clear, the NSW report notes that part of the problem is the inadequacy and inflexibility of our housing industry.

It’s simply not capable of expanding to meet the surge in demand for homes – something that, I suspect, doesn’t worry it greatly. It’s content to respond by “rationing by [higher] price”, a mechanism I explained in last week’s column.

But the NSW report says the housing industry simply doesn’t have enough tradespeople to increase its production. Workers have been lost to the major construction projects, thanks to the surge in state government spending on infrastructure.

This is no doubt right, as far as it goes. It’s certainly true that state governments would do better (and cheaper) if they timed their investment spending to fit with the ups and downs of private sector major construction spending.

But I think the ability to meet shortages of skilled workers simply by bringing workers from overseas when you need them has led the industry to neglect training sufficient apprentices to meet future needs.

Neither this report nor Treasury’s budget sermon acknowledges another possible supply-side problem, the one highlighted by the economists’ great alternative thinker on housing, Dr Cameron Murray. He argues that the developers keep house prices rising by limiting the release of land to fit.

When you look at the broader causes of ever-rising house prices, even the Reserve Bank doesn’t escape responsibility. The central bankers have always argued that housing prices are a consequence of the interaction of the demand for housing and its supply, so nothing to do with them.

Again, that’s true as far as it goes. But it sidesteps the more behavioural possibility that whacking interest rates up and down engenders an “irrational” FOMO – fear of missing out – that helps keep house prices rising when rates are falling and even when rates are rising and could rise further.

If so, that’s yet another reason why the economists need to come up with a better way of limiting demand than just screwing young people with big mortgages.

There’s more to ever-rising house prices than has ever crossed the minds of most economists.

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Fixing inflation doesn't have to hurt this much

They say that the most important speeches politicians make are their first and their last. Certainly, I’ve learnt a lot from the last thoughts of departing Reserve Bank governors. And, although Dr Philip Lowe still has one big speech to go, he’s already moved to a more reflective mode.

Whenever smarty-pants like me have drawn attention to the many drawbacks of using higher interest rates to bash inflation out of the economy, Lowe’s stock response has been: “Sorry, interest rates are the only lever I’ve got.”

But, in his last appearance before a parliamentary committee on Friday, he was more expansive. He readily acknowledged that interest rates – “monetary policy” – are a blunt instrument. They hurt, they’re not well-targeted and do much collateral damage.

“Monetary policy is effective, but it also has quite significant distributional effects,” he said. “Some people in the community are finding things really difficult from higher interest rates, and other people are benefiting from it.”

Higher interest rates don’t have much effect on the behaviour of businesses – except, perhaps, landlords who’ve borrowed heavily to buy investment properties – but they do have a big effect on people with mortgages, increasing their monthly payments and so leaving them with less to spend on everything else.

That’s the object of the exercise, of course. Prices – the cost of living – rise when households’ spending on goods and services exceeds the economy’s ability to produce those goods and services. So economists’ standard solution is to use higher interest rates to squeeze people’s ability to keep spending. Weaker demand makes it harder for businesses to keep raising their prices.

Trouble is, only about a third of households have mortgages, with another third renting and the last third having paid off their mortgage. This is what makes using interest rates to slow inflation so unfair. Some people get really squeezed, others don’t. (Rents have been rising rapidly, but this is partly because the vacancy rate is so low.) What’s more, some long-standing home buyers don’t owe all that much, so haven’t felt as much pain as younger people who’ve bought recently and have a huge debt.

Who are the people Lowe says are actually benefiting from higher interest rates? Mainly oldies who’ve paid off their mortgages and have a lot of money in savings accounts.

In theory, the higher rates banks can charge their borrowers are passed through to the savers from whom the banks must borrow. Some of it has indeed been passed on to depositors, but the limited competition between the big four banks has allowed them to drag their feet.

So the “significant distributional effects” Lowe refers to are partly that the young tend to be squeezed hard, while the old get let off lightly and may even be ahead on the deal. And the banks always do better when rates are rising.

All this makes the use of interest rates to control inflation unfair in the way it affects different households. And note this: how is it fair to screw around with the income of the retired and other savers? They do well at times like this but pay for it when the Reserve is cutting interest rates to get the economy back up off the floor.

But as well as being unfair, relying on interest rates to slow the economy is a less effective way to discourage spending. Because raising interest rates directly affects such a small proportion of all households – the ones with big mortgages – the Reserve has to squeeze those households all the harder to bring about the desired slowdown in total spending by all households.

In other words, if the squeeze was spread more evenly between households, we wouldn’t need to put such extreme pressure on people with big mortgages.

Lowe has been right in saying, “Sorry, interest rates are the only lever I’ve got.” What he hasn’t acknowledged until now is that the central bank isn’t the only game in town. The government’s budget contains several potential levers that could be used to slow the economy.

We could set up an arrangement where a temporary rise in the rate of the goods and services tax reduced the spending ability of all households. Then, when we needed to achieve more spending by households, we could make a temporary cut in the GST.

If we didn’t like that, we could arrange for temporary increases or decreases in the Medicare levy on taxable income.

Either way of making it harder for people to keep spending would still involve pain, but would spread the pain more fairly – and, by affecting all or most households, be more effective in achieving the required slowdown in spending.

The least painful way would be to impose a temporary increase or decrease in employees’ compulsory superannuation contributions. That way, no one would lose any of their money, just be temporarily prevented from spending it at times when too much spending was worsening the cost of living.

Our politicians and their economic advisers need to find a better way to skin the cat.

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Hate rising prices? Please blame supply and demand, not me

Have you noticed how, to many economists, everything gets back to the interaction of supply and demand? Understand this simple truth and you know all you need to know. Except that you don’t. It leaves much to be explained.

Why has the cost of living suddenly got much worse? Because the demand for goods and services has been growing faster than the economy’s ability to supply those goods and services, causing businesses to put their prices up.

Since there is little governments can do to increase supply in the short term, the answer is to use higher interest rates to discourage spending. Weaker demand will make businesses much less keen to keep raising their prices. If you hit demand really hard, you may even oblige businesses to lower their prices a little.

But, as someone observed to me recently, saying that everything in the economy is explained by supply and demand is a bit like saying every plane crash is explained by gravity. It’s perfectly true, but it doesn’t actually tell you much.

Consider this. After rising only modestly for about a decade, rents are now shooting up. Why? Well, some people will tell you it’s because almost half of all rental accommodation has been bought by mum and dad investors using borrowed money (“negative gearing” and all that).

The sharp rise in interest rates over the past year or so has left many property investors badly out of pocket, so they’ve whacked up the rent they’re charging.

Ah no, say many economists (including a departing central bank governor), that’s not the reason. With vacancy rates unusually low, it means that the demand for places to rent is very close to the supply available, and landlords are taking advantage of this to put up their prices.

So, what’s it to be? I think it’s some combination of the two. Had the vacancy rate been high, mortgaged landlords would have felt the pain of higher interest rates but been much less game to whack up the rent for fear of losing their tenants.

But, by the same token, it’s likely that the coincidence of a tight housing market with a rise in interest rates has made the rise in rents faster and bigger than it would have been. It would be interesting to know whether landlords with no debt have increased their prices as fast and as far as indebted landlords have.

The point is that knowing how the demand and supply mechanism works doesn’t tell you much. It doesn’t allow you to predict what will happen to either supply or demand, nor tell you why they’ve moved as they have.

It’s mainly useful for what economists call “ex-post rationalisation” – aka the wisdom of hindsight.

Economic theory assumes that all businesses – including landlords – are “profit-maximising”. But in their landmark book, Radical Uncertainty, leading British economists John Kay and Mervyn King make the heretical point that, in practice rather than in textbooks, firms don’t maximise their profits.

Why not? Well, not because they wouldn’t like to, but because they don’t know how to. There is a “price point” that would maximise their profits, but they don’t know what it is.

To economists, when you’re just selling widgets, it’s a matter of finding the right combination of “p” (the price charged) and “q” (the quantity demanded). Raising p should increase your profit – but only if what you gain from the higher p is greater than what you lose from the reduction in q as some customers refuse to pay the higher price.

What you need to know to get the best combination of p and q is “the price elasticity of demand” – the customers’ sensitivity to changes in price. In textbooks or mathematical models, the elasticity is either assumed or estimated via some empirical study conducted in America 30 years ago.

In real life, you just don’t know, so you feel your way gently, always standing ready to start discounting the price if you realise you’ve gone too far. And the judgments you make end up being influenced by the way you feel, the way your fellow traders feel, what you think the customers are feeling and how they’d react to a price rise.

How flesh-and-blood people behave in real markets is affected by mood, emotion, sentiment, norms of socially acceptable behaviour and other herding behaviour – all the factors that economists knowingly exclude from their models and know little about.

Keynes called all this “animal spirits”. Youngsters would call it “the vibe of the thing”. It’s psychology, not economics. And it’s because conventional economics attempts to predict what will happen in the economy without taking account of airy-fairy psychology that economists’ forecasts are so often wrong.

They may know more about how the economy works than the rest of us, but there’s still a lot they don’t know. Worse, many of them don’t think they need to know it.

It’s clear to me that psychology has played a big part in the great post-pandemic price surge. It didn’t cause it, but it certainly caused it to be bigger than it might have been.

The pandemic’s temporary disruptions to supply and the Ukraine war’s disruption to fossil fuels and food supply provided a cast-iron justification for big price rises, and it was a simple matter for businesses to add a bit extra for the shareholders.

It was clear to the media that big price rises were on the way, so they went overboard holding a microphone in front of every industry lobbyist willing to make blood-curdling predictions about price rises on the way. (I’m still waiting to see the ABC’s prediction of the price of coffee rising to $8 a cup.)

Thus did recognition that the time for margin-fattening had arrived spread from the big oligopolists to every corner store. One factor that constrains the prices of small retailers is push-back from customers – both verbal and by foot.

All the media’s fuss about imminent price rises softened up customers and told the nation’s shopkeepers there would be little push-back to worry about.

In the home rental market, dominated as it is by amateur small investors, who rightly worry about losing a tenant and having their property unoccupied for more than a week or two, it’s the commission-motivated estate agents who know when’s the right time to urge landlords to raise the rent, and how big an increase they can be confident of getting away with. 

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Don't be so sure we'll soon have inflation back to normal

Right now, we’re focused on getting inflation back under control and on the pain it’s causing. But it’s started slowing, with luck we’ll avoid a recession, and before long the cost of living won’t be such a worry. All will be back to normal. Is that what you think? Don’t be so sure.

There are reasons to expect that various factors will be disrupting the economy and causing prices to jump, making it hard for the Reserve Bank to keep inflation steady in its 2 per cent to 3 per cent target range.

Departing RBA governor Dr Philip Lowe warned about this late last year, and the Nobel Laureate Michael Spence, of Stanford University, has given a similar warning.

A big part of the recent surge in prices came from disruptions caused by the pandemic and the invasion of Ukraine. Such disruptions to the supply (production) side of the economy are unusual.

But Lowe and Spence warn that they’re likely to become much more common.

For about the past three decades, it was relatively easy for the Reserve and other rich-country central banks to keep the rate of inflation low and reasonably stable.

You could assume that the supply side of the economy was just sitting in the background, producing a few percentage points more goods and services each year, in line with the growth in the working population, business investment and productivity improvement.

So it was just a matter of using interest rates to manage the demand for goods and services through the undulations of the business cycle.

When households’ demand grew a bit faster than the growth in supply, you raised interest rates to discourage spending. When households’ demand was weaker than supply, you cut interest rates to encourage spending.

It was all so easy that central banks congratulated themselves for the mastery with which they’d been able to keep things on an even keel.

In truth, they were getting more help than they knew from a structural change – the growing globalisation of the world’s economies as reduced barriers to trade and foreign investment increased the trade and money flows between the developed and developing economies.

The steady growth in trade in raw materials, components and manufactured goods added to the production capacity available to the rich economies. Oversimplifying, China (and, in truth, the many emerging economies it traded with) became the global centre of manufacturing.

This huge increase in the world’s production capacity – supply – kept downward pressure on the prices of goods around the world, thus making it easy to keep inflation low.

Over time, however – and rightly so – the spare capacity was reduced as the workers in developing countries became better paid and able to consume a bigger share of world production.

Then came the pandemic and its almost instantaneous spread around the world – itself a product of globalisation. But no sooner did the threat from the virus recede than we – and the other rich countries – were hit by the worst bout of inflation in 30 years or so.

Why? Ostensibly, because of the pandemic and the consequences of our efforts to limit the spread of the virus by locking down the economy.

People all over the world, locked in their homes, spent like mad on goods they could buy online. Pretty soon there was a shortage of many goods, and a shortage of ships and shipping containers to move those goods from where they were made to where the customers were.

Then there were the price rises caused by Russia’s war on Ukraine and by the rich economies’ trade sanctions on Russia’s oil and gas. So, unusually, disruptions to supply – temporary, we hope – are a big part of the recent inflation surge.

But, the central bankers insist, the excessive zeal with which we used government spending and interest-rate cuts to protect the economy and employment during the lockdowns has left us also with excess demand for goods and services.

Not to worry. The budget surplus and dramatic reversal of interest rates will soon fix that. Whatever damage we end up doing to households, workers and businesses, demand will be back in its box and not pushing up prices.

Which brings us to the point. It’s clear to Lowe, Spence and others that disruptions to the supply side of the economy won’t be going away.

For a start, the process of globalisation, which did so much to keep inflation low, is now reversing. The disruption to supply chains during the pandemic is prompting countries to move to arrangements that are more flexible, but more costly.

The United States’ rivalry with China, and the increasing imposition of trade sanctions on countries of whose behaviour we disapprove, may move us in the direction of trading with countries we like, not those offering the best deal. If so, the costs of supply increase.

Next, the ageing of the population, which is continuing in the rich countries and spreading to China and elsewhere. This reduction in the share of the population of working age reduces the supply of people able to produce goods and services while the demand for goods and services keeps growing. Result: another source of upward pressure on prices.

And not forgetting climate change. One source of higher prices will be hiccups in the transition to renewable energy. No new coal and gas-fired power stations are being built, but the existing generators may wear out before we’ve got enough renewable energy, battery storage and expanded grid to take their place.

More directly, the greater frequency of extreme weather events is already regularly disrupting the production of fruit and vegetables, sending prices shooting up.

Drought prompts graziers to send more animals to market, causing meat prices to fall, but when the drought breaks, and they start rebuilding their herds, prices shoot up.

Put this together and it suggests we’ll have the supply side exerting steady underlying – “structural” – pressure on prices, as well as frequent adverse shocks to supply. Keeping inflation in the target range is likely to be a continuing struggle.

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Why inflation is easing while rents are rising - and will keep going

It never rains but it pours. With the prices of so many things in the supermarket shooting up, now it’s rents that are rising like mad. Actually, while the overall rate of inflation is clearly slowing, rents are still on the up and up. What’s going on?

The Australian Bureau of Statistics’ consumer price index (CPI) showed prices rising by 0.8 per cent over the three months to the end of June, and by 6 per cent over the year to June. That’s down from 7.8 per cent over the year to December.

But rents in Sydney rose by 7.3 per cent over the year to June, up from 3.3 per cent over the year to December. Rents in Melbourne are now up by 5 per cent, compared with 2.2 per cent to last December.

But hang on. Those increases seem low. I’ve been reading and hearing about rent increases much bigger than that. What gives?

You’ve been reading about bigger rent increases than the CPI records because what gets most notice in the media is what economists call “advertised” rents – the asking price for presently vacant properties that have been listed with real estate agents.

So, this is the most relevant price for someone who’s decided to rent, or is wishing to move. Remember, however, in normal times landlords don’t always get as much as they ask for initially. Times like now, when the market’s so tight, they may end up with more.

But, each month, only 2 or 3 per cent of properties have a change in tenants. So most people are existing renters, wanting to sit tight, not move. It’s a safe bet they’re paying less that the price being asked of new tenants. And, though their rent will be increased soon enough, it hasn’t been yet.

The stats bureau’s increases are lower than the asking price because they include the rents actually being paid by all capital-city renters, not just the new ones.

But if the asking price is a lot higher than the average of the rents being paid by everyone, this is a good sign the average will keep going up. The rent increase is working its way through the system, so to speak.

But why are asking prices rising so much? Ask any economist, and they’ll tell you without looking: if the demand for rental accommodation exceeds the supply available, prices will rise.

That’s true. And the way we know it’s true is that vacancy rates are much lower than usual.

It’s when vacancy rates are low that landlords know now would be a good time to put up the rent. If the landlord has borrowed to buy the rental property, the rise in the interest rates they’re paying will make them very keen to do so.

But more than half of all rental properties are owned debt-free. Those landlords will probably also be keen to take advantage of this (surprisingly rare) chance to increase their prices by a lot rather than a little.

When demand is outstripping supply, the economists’ knee-jerk reaction is that we need more supply. Rush out and build a lot more rental accommodation.

But the economists who actually study the rental market aren’t so sure that’s called for. If you look back over the past decade, you see little sign that the industry has had much trouble keeping the supply up with demand.

If anything, the reverse. Until the end of 2021, rents went for years without rising very fast. Especially compared with other consumer prices, and with people’s incomes. Indeed, there were times when rents actually fell.

You didn’t know that? That’s because the media didn’t tell you. Why? Because they thought you were only interested in bad news. (And they were right.)

What’s too easily forgotten is all the ructions the rental market went through during the pandemic. What’s happening now is a return to something more normal. It’s all explained in one of the bureau’s information papers.

Official surveys show that renters tend to younger and have lower incomes than homeowners, and to devote a higher share of their disposable (that is, after-tax) income to housing costs. This is why so many renters feel the recent rent rises so keenly. And also, why the pressure is greater on people renting apartments rather than houses.

The pandemic, with its changes in population flows, vacancy rates and renters’ preferences, had big effects on rents and renters. Early in the pandemic, demand for rental properties in the inner-city markets (that is, within 12.5 kilometres of the CBD) of Sydney and Melbourne declined, as international students returned home, international migration stopped and some young adults moved back in with their parents.

Some landlords offering short-term holiday rentals switched to offering longer-term rental, further increasing the supply of rental accommodation. And the need to work from home prompted some renters to move from the inner city to suburbs further out, where the same money bought more space.

This is why inner-city rents fell during the first two years of the pandemic. Also, state governments introduced arrangements helping tenants who’d become unemployed or lost income to negotiate temporary rent reductions.

But inner-city rental markets began tightening up in late 2021, as the lockdowns ended and things began returning to normal. Some singles who’d gone back home or packed into a share house began seeking something less crowded. And, eventually, international students began returning.

So, we’ve gone from the supply of rental accommodation exceeding demand, back to stronger demand. Rents that were low or even falling are going back up.

As an economist would say, with the pandemic over, the rental market is returning to a new “equilibrium” – a fancy word for balance between supply and demand.

What we’re seeing is not so much a “crisis” as a catch-up. One reason it’s happening so fast is the higher interest rates many landlords are paying. But another reason renters are finding it so hard to cope with is that other consumer prices have risen a lot faster than their disposable incomes have.

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RBA warning: our supply-side problems have only just begun

In one of his last speeches for the year, Reserve Bank governor Dr Philip Lowe has issued a sobering warning. Even when we’ve got on top of the present inflation outbreak, the disruptions to supply we’ve struggled with this year are likely to be a recurring problem in the years ahead.

Economists think of the economy as having two sides. The supply side refers to our production of goods and services, whereas the demand side refers to our spending on those goods and services, partly for investment in new production capacity, but mainly for consumption by households.

Lowe notes that, until inflation raised its ugly head, the world had enjoyed about three decades in which there were few major “shocks” (sudden big disruptions) to the continuing production and supply of goods and services.

When something happens that disrupts supply, so that it can’t keep up with demand, prices jump – as we’ve seen this year with disruptions caused by the pandemic and its lockdowns, and with Russia’s attack on Ukraine.

What changes occurred over the three decades were mainly favourable: they involved increased supply of manufactured goods, in particular, which put gentle downward pressure on prices.

This made life easier for the world’s central banks. With the supply side behaving itself, they were able to keep their economies growing fairly steadily by using interest rates to manage demand. Put rates up to restrain spending and inflation; put rates down to encourage spending and employment.

The central banks were looking good because the one tool they have for influencing the economy – interest rates – was good for managing demand. Trouble is – and as we saw this year – managing demand is the only thing central banks and their interest rates can do.

When prices jump because of disruptions to supply, there’s nothing they can do to fix those disruptions and get supply back to keeping up with demand. All they can do is strangle demand until prices come down.

So, what’s got Lowe worried is his realisation that a lot of the problems headed our way will be shocks to supply.

“Looking forward, the supply side looks more challenging than it has been for many years” and is likely to have a bigger effect on inflation, making it jump more often.

Lowe sees four factors leading to more supply shocks. The first is “the reversal of globalisation”.

Over recent decades, international trade increased significantly relative to the size of the global economy, he says.

Production became increasingly integrated across borders, and this lowered costs and made supply very flexible. Australia was among the major beneficiaries of this.

Now, however, international trade is no longer growing faster than the global economy. “Trading blocs are emerging and there is a step back from closer integration,” he says. “Unfortunately, today barriers to trade and investment are more likely to be increased than removed.”

This will inevitably affect both the rise in standards of living and the prices of goods and services in global markets.

The second factor affecting the supply side is demographics. Until relatively recently, the working-age population of the advanced economies was steadily increasing. This was also true for China and Eastern Europe – both of which were being integrated into the global economy.

And the participation of women in the paid labour force was also rising rapidly. “The result was a substantial increase in the number of workers engaged in the global economy, and advances in technology made it easier to tap into this global labour force,” Lowe says.

So, there was a great increase in global supply. But this trend has turned and the working-age population is now declining, with the decline projected to accelerate. The proportion of the population who are either too young or too old to work is rising, meaning the supply of workers available to meet the demand for goods and services has diminished.

The third factor affecting the supply side is climate change. Over the past 20 years, the number of major floods across the world has doubled and the frequency of heatwaves and droughts has also increased.

This will keep getting worse.These extreme weather events disrupt production and so affect prices – as we know all too well in Australia. But as well as lifting fruit and vegetable prices (and meat prices after droughts break and herd rebuilding begins), extreme weather can disrupt mining production and transport and distribution.

The fourth factor affecting the supply side is related: the transition from fossil fuels to renewables. This involves junking our investment in coal mines, gas plants and power stations, and new investment in solar farms, wind farms, batteries and rooftop solar, as well as extensively rejigging the electricity network.

It’s not just that the required new capital investment will be huge, but that the transition from the old system to the new won’t happen without disruptions.

So, energy prices will be higher (to pay for the new capital investment) and more volatile when fossil-fuel supply stops before renewables supply is ready to fill the gap.

Lowe foresees the inflation rate becoming more unstable through two channels. First, shocks to supply that cause large and rapid changes in prices.

Second, the global supply curve becoming less “elastic” (less able to respond to increases in demand by quickly increasing supply) than it has been in the past decade.

Lowe says bravely that none of these developments would undermine the central banks’ ability to achieve their inflation target “on average” - that is, over a few years – though they would make the bankers’ job more complicated.

Well, maybe. As he reminds us, adverse supply shocks can have conflicting effects, increasing inflation while reducing output and employment. The Reserve can’t increase interest rates and reduce them at the same time.

As Lowe further observes, supply shocks “also have implications for other areas of economic policy”. Yes, competition policy, for instance.

My conclusion is that managing the economy can no longer be left largely to the central bankers.

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Treasury thinks the unthinkable: yes, intervene in the gas market

If you think economists say crazy things, you’re not alone. Speaking about our soaring cost of living this week, Treasury Secretary Dr Steven Kennedy told a Senate committee that “the solution to high prices is high prices”. But then he said this didn’t apply to the prices of coal and gas.

How could anyone smart enough to get a PhD say such nonsense? He even said – in a speech actually read out by one of his deputies – that this piece of crazy-speak was something economists were “fond of saying”.

It’s true, they are. If they were children, we’d call it attention-seeking behaviour. But when you unpick their little riddle, you learn a lot about why economists are in love with markets and “market forces”, why they’re always banging on about supply and demand, and why (as I’ve said once or twice before) if economists wore T-shirts, what they’d say is “Prices make the world go round”.

At the heart of conventional economics – aka the “neo-classical model” – lies the “price mechanism”. Understand this, and you understand why the thinking of early economists such as Adam Smith and Alfred Marshall is still influential a century or two after their death, and why, of all the people seeking the ears of our politicians, economists get more notice taken of their advice than other professions do.

The secret sauce economists sell is their understanding of how a lot of seemingly big problems go away if you just give the price mechanism time to solve them.

A market is a place or a shop or cyberspace where people come to sell things to other people. The sellers are supplying the item; the buyers are demanding it. The seller sets the price; the buyer accepts it – or sometimes they haggle or hold an auction.

If the price of some item rises, this draws a response from the price mechanism, which is driven by market forces – the interaction of supply on one side and demand on the other.

The price rise sends a signal to buyers and a signal to sellers. The message buyers get is: this stuff’s more expensive, so make sure you’re not wasting any of it.

And see if you can find a substitute for it that’s almost as good but doesn’t cost as much. If you’ve been buying the deluxe, big-brand version, try the house brand.

On the other side, the message to sellers is: since people are paying more for this stuff, produce more of it. “I’m not in this business, but maybe now the price is higher, I should be.” If the price has risen because the firm’s costs have risen, maybe we could find a way to cut those costs, not put our price up and so pinch customers from our competitors.

See where this is going? If customers react to the higher price by buying less, while sellers react by producing more, what’s likely to happen to the price?

If demand for the item falls, and the supply of the item increases, the higher price should come back down.

Saying the solution to high prices is high prices is a tricky way of saying market forces will react to the price rise in a way that, after a while, brings it back down again.

When demand and supply get out of balance, market forces adjust the price up or down until demand and supply are back in balance. The price mechanism has fixed the problem, returning the market to “equilibrium”.

This is the origin of the old economists’ motto: laissez-faire. Leave things alone. Don’t interfere. Interfering with the mechanism will stop it working properly and probably make things worse rather than better.

There’s a huge degree of truth to this simple analysis. At this moment there are thousands of firms and millions of consumers reacting to price changes in the way I’ve just described.

Kennedy admits that “there are many conditions that underpin” this do-nothing policy, but “in most circumstances Treasury would support such an approach”.

There certainly are many simplifying assumptions behind that oversimplified theory. It assumes all buyers and sellers are so small they have no power by themselves to influence the price.

It assumes all buyers and all sellers know all they need to know about the characteristics of the product and the prices at which it’s available. It assumes competition in the market is fierce. And that’s just for openers.

However, Kennedy said, the circumstances of the price shocks caused by the Ukraine war are “different and outside the frame” of Treasury’s usual approach. Such shocks bring government intervention in the coal and gas markets “into scope”. That is, just do it.

“The current gas and thermal coal price increases are leading to unusually high prices and profits for some companies,” he said. “Prices and profits well beyond the usual bounds of investment and profit cycles.

“The same price increases are leading to a reduction in the real incomes of many people, with the most severely affected being lower-income working households.

“The energy price increases are also significantly reducing the profits of many [energy-using] businesses and raising questions about their viability.”

In summary, Kennedy said, the effects of the Ukraine war are leading to a redistribution of income and wealth, and disrupting markets. “The national-interest case for this redistribution is weak, and it is not likely to lead to a more efficient allocation of resources in the longer term,” he said.

(The efficient allocation of resources – land, labour and capital – is the main reason economists usually oppose government intervention in the price mechanism. Markets usually allocate resources most efficiently.)

The government’s policy response to the problem could take many forms, Kennedy said, but with inflation already so high, policymakers “need to be mindful of not contributing further to inflation”.

This suggests that intervening to directly reduce coal and gas prices is more likely to be the best way to go, he concluded.

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