Inflation and Interest Rates: Why it may be more complex than we think.
Nikesh Lalchandani
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In recent times we have seen high inflation impact many countries. In undisciplined monetary systems, prolonged high inflation is an economic disease that many fear. So traditional monetary policy requires that in order to reduce inflation, we need to increase interest rates. This discourages spending and helps restore inflation. However, this aged formula may no longer work.?Here are 15 issues with the current system.
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1.One basket to rule them all.
Inflation needs to be measured. The typical measurement is the Consumer Price Index. This index is made up of typical purchases an average person makes in the week. It was a simple basket post World War II:?bread, milk, lamb, etc.
The first issue is populations are much more diverse than they were before, and they have diverse spending habits. What is in your basket may not be in my basket.?A gluten-free vegan will neither have bread, milk nor lamb in their basket. The use of averages is meant to overcome this issue, however already you can see that with increasingly diverse baskets, you could experience diverse inflation. We still use surveys (in Australia: 8,000 households) to determine the basket, and we separate the process of pricing. It is not a total view of economic produce. Surveys like these could bias traditional households and spending.
2. A rapidly changing world
The second issue is to do with changes. Behaviours are changing at a pace faster than ever before. These behaviours could be driven by trends, technology, or in the case of the pandemic – government mandates. Increased automation, globalisation and online capability are perhaps the three biggest shocks we are seeing. Previously we would purchase goods in store. Increasingly we are purchasing online. The prices will differ. If you are more of an online shopper, your basket will be very different to another, especially from a price point of view. We live in a global economy, and increasingly, our purchases may be more and more from overseas. We may rent and borrow rather than own (e.g. rideshare vs cars). Recent times have seen a move from commuting to telecommuting: this means less money on travel, decentralisation of the workforce, and potentially a shift in what we purchase: less suits, more residential home-office equipment. Due to environmental concerns, we may spend less on petrol and more on batteries.
Covid saw a shift in spending from services to goods. With everyone buying more goods (e.g. toilet paper) it was logical to see inflation in goods. A return to relative normality, saw a shift back to services.?This group action should naturally cause inflation as everyone has a simultaneous spending bias, when compared to a time when there was not one.
None of this information is new, or unknown. Indeed the people who measure CPI are more acutely aware of the issues than others. In Australia for example, by default the basket is adjusted every six years. During and after Coivd, the basket was updated due to rapid changes in spending habits. This brings us to our third issue.
3. Out of phase compensation
We are changing the components of the CPI basket faster than before. There is always a delay in measurement: so behaviours are not always aligned with the basket, and if you simultaneous change the yard stick and object of measurement, the accuracy of the measurement is compromised, and the baseline is not always clear. While measures are taken to compensate, given significant decisions ride on small fluctuations of the CPI, can we be confident we got it right?
The end of Covid saw the end of lockdowns. Simultaneously people?were travelling at the same time: as many had not holidayed for two or three years. The travel and tourism industry saw a significant boom, and this resulted in considerable price inflation in that sector. However eventually travel diaries will desynchronise, and that momentary inflation will, by itself resolve. The money we saved for travelling was either saved or will be paid back over a period longer than our spending window: was it right to include it in our inflationary calculations?
4. Debt based economy
We have had few high interest periods in the last several decades. We don’t have sufficient experience on how debt based economies respond to significant shifts in monetary policy. The fact for many economies is the increased debt levels means that now, more than at any time in the past, people are more susceptible to interest rates, and even small changes can have significant impacts.
The other issue is that interest rates impact some more than others: this cohort could be (in normal times) larger spenders than others, so is our measure of inflation exaggerated?
5. Feedback cycle
The feedback period of changes to interest rates on prices is long. Rarely will manufacturers change their price in immediate response to interest rates. Interest rates do effect investment and purchasing decisions, and this impacts demand and eventually demand impacts price. However the feedback period is long. Now given the fact that we are changing the basket and measurement at a faster rate, we are not giving it enough time to play out: we really don’t know the impact as there is limited precedent, especially given current conditions. We could find we have over compensated and will end up over attenuating a delicate balance.
6. Substitution
If the cost of my basket goes up, and I am faced with increased interest rates to tighten spending, two things could happen: the basket can shrink or I could substitute. I could select a "no-frills" brand or squeeze my own oranges. Maybe I don't need two online streaming services. So it may be possible that at a particular time, the basket is not reflective of my actual spending.?So just say the Basket was worth $100 last year, and $107 this year. If I am only paying $95 to meet my needs, forgoing and substituting some parts of the basket, the effective inflation is negative 5% despite the headline being 7%. Collectively, re-constituting the basket may not happen fast enough. We could see this phenomena in a rapidly slowing economy (manifest as stagflation).
7. Once bitten twice shy
Having faced harsh times, people impacted by a slow down will endure a generational lesson of frugality. They will reduce spending and borrowing even after recovery. Pushing an economy into a recession could curtails its growth for longer than many think, and it could take a generation to restore confidence. This is why sharp changes to monetary policy should be treated carefully.
8. “Good inflation” and “bad inflation”
In a world where there is too much money, and not enough production, prices will go up. In a simple economy with a butcher, baker, and candlestick maker, and stagnant demand, decreasing money supply through higher interest rates allows supply to keep up with demand at a reasonable price point: because you only have so many butchers etc.
But what about sophisticated advancing economies, where candles are being replaced by new technology at a rapid rate: incandescent lights, then fluorescent lights and LEDs?
Once the new superior technology comes out, we see a price jump. This is natural: supply is limited, and demand is growing faster than supply can keep up with as people see the value of the new tech. To add to the problems, the smart candlestick makers see the writing on the wall, and are going to school to learn how to make LED lights, so you can’t even buy a cheap candle anymore.
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Or another example is what we are seeing now: geo-political forces are at play that are removing traditional suppliers from our supply chain, creating a shortage of materials and leading to inflation in some areas.
Now THAT inflation is good.?Why? It acts as an incentive to rewire the economy. We stopped manufacturing in Australia because labour was cheaper in China. But now that Chinese workers want smart phones, electric vehicles and a modern apartment, their salaries have gone up, and so have the goods they produce: manifesting as inflation. With increased automation does it really matter how much you pay workers? Could we start manufacturing in countries that were previously cost prohibitive?
So my car plant that could not compete at $20,000 per vehicle is viable again in a market where high-tech robot-manufactured electric vehicles sell for $60,000. But what if you raise interest rates due to apparent inflation? Any new entrants will be disincentivised: they can’t access capital, and local demand has been stifled temporarily. The early-entrant price incentive is neutralised and the Geoffrey A. Moore’s “Chasm” is prolonged: killing off potentially viable innovative businesses. By the time interest rates are restored and the economy is growing again, pre-established suppliers have filled the void, and we never get those favourable conditions again until the next shock.
Good inflation is a necessary incentive to reconfigure our industries, and help new suppliers develop. Curtailing this inflation keeps our industries and economy stagnant.
9. Value of money vs goods and services
Monetary policy is designed to control the value of money, not goods and services. You may ask what's the difference? When all goods and services go up in value simultaneously, there has been a uniform decline in money. When it seems to be concentrated in industries or sectors, like it is now, the problem lies with the produce. What we may be seeing is the underlying increase in the value of specific goods and services, not money itself. If this is the case then we are fixing the wrong problem. There are better ways to decrease the costs of goods and services: e.g. incentives and organic competition etc.
10. Inflation becomes a vicious cycle
If as a community, we believe that a macro uniform inflation is a thing, then we may enter a vicious cycle. The increase in prices (due to natural factors or structural changes in demand) results in the justification of an increase in wages, which then increases prices again, etc, when originally the cause of the inflation may have been limited to specific jobs or specific goods.
So take for example organisations that wish to invest in artificial intelligence. Building the infrastructure is a capital investment, and calls on a limited specialised workforce that are able to demand a higher salary. The goods produced become more expensive, the hype associated may contribute to the price surge, and collectively this may impact headline inflation. Then people who did not get a pay rise can claim one based on an increase in inflation, despite not having emerging skills or producing these emerging products or improvements... resulting in an actual impact to macro inflation.
11. Growth and contraction are individual psychological states
Macroeconomists try and look at the economy as a single large beast. Market traders like the market to act as a contiguous whole.
“Consumer confidence” is often used as a prediction of future growth. Really speaking, the growth potential of the economy is an attitude in our collective heads. What monetary policy does, is push a certain agenda to everyone. It tries to force our psychology.?So just say a central bank indicates higher interest rates. This means that they want a slow down. The market will expect a slowdown. A large corporate, to meet expectations will want to demonstrate profits in a reduced income market – the only way they can do this is to reduce costs. They will pre-empt the economic effects by laying off staff, even if they have not actually seen a drop in demand yet. This will reduce employment, and really reduce demand. Collectively this will force a negative sentiment even if there was not one. It is like the Pavlov’s dogs: we are trained to simultaneously act on a single external signal.
12. Market price bias
When measuring prices, we tend to bias based on current market price. The market price is not the price that everyone would or did purchase an item. It is the current rate based on buyers sellers. The use of current market prices could exagerate the effect of a quickly changing price. Some purchases may have taken place before market changes, and purchases may be delayed in response to a price surge, or brought forward in response to a discount. This effect may not be properly accounted for in the calculation of inflation.
13. Loss of confidence in the monetary system
Many people don’t realise how much rides on our collective confidence in the current money system. Gradually since the Bretton Woods conference towards the end of World War II, the foundation of money has been eroded. It was once based on an independent, globally accepted commodity: Gold. It has now dissipated into almost entirely nationally controlled currencies, primarily the US dollar. ?Bitcoin was born in 2007 out of a lack of confidence in what has come to be known as the “fiat” money system. While Bitcoin has not been successful to a significant extent, the rise of cryptocurrency has at least achieved one objective – communicated this loss of faith, and provided at least theoretically, a possible alternative. Before Bitcoin, the security of money was beyond dispute to many, these days, not so much: even if we don’t have a crypto coin, many get the philosophy, and the seed of doubt in the money system has been planted. Also, it is worth knowing that at least Russia and China have expressed dissatisfaction in the global monetary system in recent times. The worst thing that could happen, is a significant population of people lose faith in the money system and this could be devastating to the global economy.
14. Conflict of interest
Many central banks are charged with a couple of objectives: low inflation and high employment.?These are contrary objectives sometimes.?There is another unwritten objective that governments push on central banks: low interest rates.?High employment leads to high inflation: because employment is never perfectly balanced. Where you have limited workers, employers need to import or pay more for talent, which increases their costs, and prices. So in meeting their higher priority objectives, central banks could be discouraging high employment: something that is probably more important.
15. Separation of fiscal and monetary policy
Fundamentally an economy can be controlled by both fiscal and monetary policy. One is the responsibility of the executive government, the other is the responsibility of the central bank. The separation of these two, as we saw in Covid leads the central bank needing to compensate for the over response of the fiscal arms of government. Governments are reluctant to do the dirty work like raising taxes and interest rates: which is why they outsources one of these to an independent body. The issue then is that economic stability is largely left to an organisation that really has only one broad brush with which to act: so one size must fit all.
What if we get it wrong?
The impact of getting it wrong could range from a mild recession, lost economic opportunities, to a significant global loss of confidence in our mediums of exchange.
In a quickly changing world, we are finding the the same solutions that worked once may not always help us in the future. Money is going through considerable change. This is why we need to be more mindful of the effects of traditional monetary policy on our modern economy.