2024-08-28 03:47:22
There is a paradox in the way we respond to the threat of the cost of living.
On the one hand, the government provides subsidies for rent, electricity, etc., just like the federal government In this year’s budget.
On the other hand, we are told that these subsidies are inflationary because they put more free cash in the hands of consumers.
At the same time, when the cost of living rises enough to push inflation above the central bank’s target, the central bank raises interest rates to try to bring down the inflation rate.
For mortgage holders, this often pushes up repayments which are not included in standard measures of inflation but add to their living costs.
Price increases themselves are not a problem
Although we often talk about the cost of living, it is not something that bothers us too much in itself.
The cost of living, measured by the amount of money needed to meet basic needs, has been rising steadily for at least a century.
In the famous 1907 Reaper JudgmentJudge Henry Higgins ruled that the “living wage” for a family of five was 42 shillings ($4.20) a week.
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The cost of living has risen so much that it is now almost impossible to afford a cup of coffee.
At that time a loaf of bread cost four pence, but now 100x.
Yet despite the rising cost of living, no one doubts that living conditions for the average family have improved today.
The reason, of course, is that for most of the past century, incomes have been rising faster than prices.
The average weekly normal working hours income is currently close to $2000 per week500 times higher than in 1907.
What matters is not the price but the purchasing power of our disposable income (that is, our income after paying taxes, interest and unavoidable costs).
Until recently, wage growth has lagged behind price growth, which is unusual. In 2022, the year when inflation peaked, consumer prices rose 7.8% while wages grew 3.3%.
By historical standards, the price increases of 2022 are not extreme. Prices rose faster in the 1970s and 1980s, but they did not trigger a “cost of living crisis.”
But for much of the 1970s and 1980s, wages were indexed to prices, meaning they rose in lockstep with prices, so rising costs of living didn’t worry us too much.
Sharp rise in interest rates is a problem
The Reserve Bank and other central banks have responded to the 2022 inflation shock by rapidly and repeatedly raising the interest rates affected by it, the so-called Cash rate For Australia, it’s about getting inflation back to target.
It is worth noting that Australia’s inflation target has never been given a theoretical basis.
The idea of targeting consumer price inflation and the choice of a 2-3% target range are both arbitrary. They were inherited from very different circumstances in the early 1990s. judge Right-wing New Zealand Finance Minister.
Recent Review The Reserve Bank acknowledges challenges to this orthodoxy but does not consider them.
A more fundamental issue, which has not yet been properly analyzed, is the relationship between high interest rates and the purchasing power of disposable income.
Higher interest rates benefit some people while hurting others
For households with mortgage debt (mostly, but not all, young people), interest payments are deducted from disposable income, while for households with net financial wealth (mostly, but not all, older people), interest payments are a source of income.
The result is that the impact of higher interest rates is redistributed largely randomly, with losers seeing it as an increase in the cost of living and winners seeing it as a windfall that allows them to indulge in some extravagant spending.
I raised the limits of using interest rates to curb inflation at a Reserve Bank conference last year. Late 1990sbut it had little impact at the time.
Since interest rates remained largely stable and slowly declined over the next two decades, this view has primarily attracted academic interest.
Until now. From 2022, the Reserve Bank’s cash rate will increase by about 4 percentage points, the first significant increase since it adopted inflation targeting in the early 1990s.
We are now seeing the consequences of using interest rates to control inflation, even though they are poorly understood.
In line with familiar narratives, the distributional consequences are framed as Intergenerational conflict (Baby Boomers vs. Millennials) rather than the product of faulty economic policies.
If sharply higher interest rates are not the right way to control inflation, then what is? The experience of the 1980s provides an idea.
The best way is to avoid income shocks
Rather than seeking a rapid return of inflation to an arbitrary target range, we should aim to avoid large income shocks while achieving a gradual decline in inflation.
That means tying wages to prices and avoiding sharp shocks like the rate hikes of the late 1980s that left us “We have to go through a recession”.
That’s unlikely to happen anytime soon. In the meantime, it’s best to try to avoid the pitfalls inherent in talking about the “cost of living” and realize that in a world where the actual cost of living includes interest rates, a sharp rise in interest rates will do little to help the many people struggling to make ends meet.
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