Cost pressures and supply bottlenecks are not to blame for inflation

Economist Jim Rose blogs at utopiayouarestandinginit.com.

OPINION: It appears to many, and especially to Reserve Bank governors under fire, that rising commodity costs and Covid supply bottlenecks are suddenly pushing up prices.

But this is an illusion caused by the way inventories delay the effects of the large money supply increases in 2020 and 2021 on prices.

When an increased money supply causes total spending to rise because consumers now have more spare cash in their pockets, sales of businesses will increase. But sales fluctuate from day to day and week to week, so these businesses cannot immediately know that this sales increase will last.

As sales continue to rise, supermarkets will use up their inventories – of meat for example – faster.

Larger orders will be placed with meat suppliers, and inventories of these suppliers will shrink too. The retail price of meat has not yet changed because inventories have absorbed the initial impact of the increased spending.

The available wholesaler inventories are inadequate to meet the rising amounts of meat demanded at existing prices.

As a result, wholesale meat prices will rise as wholesalers bid more intensely for abattoir supplies. These higher price bids at auctions and other markets cause meat sellers to raise their prices. The higher wholesale prices in turn lead supermarkets to charge more for meat.

As higher prices work their way up the distribution chain to the consumer, they create an illusion that higher costs are pushing up prices.

Each seller honestly says that they are putting up their price because their own supply prices rose. Once prices have risen to offset the increase in the amount of money in consumers’ pockets, the same amount of, say, meat will be sold, but at a higher price.

Both costs and prices are being pulled up by the increased spending caused by a looser monetary policy. Because the price effects of more money in the economy and more spending are delayed by the depletion of inventories, hasty conclusions about the true cause of inflation are drawn.

Our inflation-rate-targeting regime weathered countless ups and downs of oil and commodity prices over the last three decades. Successive governors took credit for riding out commodity price rises and the supply bottlenecks that came with the previous boom times since 1990. But suddenly our inflation-rate-targeting regime is helpless in the face of rising global inflation and high oil prices.

The floating exchange rate since 1985 has allowed the Reserve Bank to conduct an independent monetary policy. A higher inflation rate overseas, say in the US, is offset by a depreciating US dollar against the New Zealand dollar, not higher inflation here.

Moreover, the Japanese inflation rate is still zero, despite being buffeted by the same Covid supply bottlenecks as other countries.

Blaming external forces is an old ruse at central banks. In the 1950s, when Milton Friedman read through all the annual reports of the US Federal Reserve, he found a curious pattern.

In times of prosperity, Friedman found that the US Federal Reserve said that monetary policy was a potent weapon, the skilful handling of which deserved credit for the favourable course of events.

In years of adversity, other forces are important sources of economic change, monetary policy has little leeway, and only the skilful handling of the extremely limited powers at hand to the Federal Reserve prevented conditions from getting worse.

We are in a policy crisis because the recent tightening in monetary policy by the Reserve Bank does no more than see the official cash rate play partial catch-up with a much higher inflation rate. There has been no real tightening of monetary policy.