Tuesday, May 03, 2022

Inflation (4) Different Situations

Rapid price increases can have two main causes.

  1. Monetary Policy
    Inflation of the money supply by a banking system supported by a central bank can create excessive demand for goods and services or assets. The most recent example is the massive growth in the money supply created by the US Federal Reserve and assisted by central banks around the world, which has caused a massive increase in the price of financial assets, especially share markets.

    In New Zealand, the monetary expansion has fed into a boom in house prices and rapid escalation of costs in the construction sector. Rapid growth in the number of houses being built has caused shortages of building materials and personnel shortages that have fed into a massive increase in prices.

    Tightening monetary policy is now taking the heat out of the property market (just as it is popping the share price bubble in the US) so we can expect inflation in the construction sector to ease, although residential dwellings will continue to be expensive.

  2. Economic Conditions
    Another cause of price increases is a change in economic conditions that brings a change in relative prices. Some prices rise fast, while others fall. In a free market, the prices of things that people want more of, or which have become scarce, tend to rise. The prices of things that people want less of tend to fall.

    The market rewards businesses that are producing things that people need more of by raising prices to increase their profitability. Businesses that are producing goods and services for which there is declining demand are punished by falling prices that eat into their profits. Some of the least viable of these businesses will actually fail. This process is how the market shifts productive capital to where it is needed most.

    We are currently facing a massive economic shift caused by war and the economic sanctions imposed by the United States. The result will be a shortage of basic food and energy that pushes up prices for these goods. Businesses and countries that produce energy products and grow grain are being rewarded with increasing prices which will increase their profitability. Countries that rely on imported energy and grain products are facing seriously price increases for essential goods that are needed throughout their economy.

    This big economic shift is making countries like New Zealand less well off. The mechanism by which this loss of prosperity is transmitted through the economy is a massive increase in prices. Oil-based products are used throughout the economy so increases in energy prices will push up the cost of everything that is produced, transported and consumed. Increased grain prices will push up the cost of many food products.

    The consequence of these changes is that our incomes will not go as far as they did in the past. Most people will all be worse off. Groups with economic power will try to get compensation for their lost prosperity by demanding an increase in income, but most will not have that privilege. Rises in the prices of food will affect everyone, but those who spend a large share of their income on food will experience the worst pain. People who are poor will be affected the most by increases in the price of food.

New Zealand is an agricultural country, but most of the food we produce is meat and milk for consumers who are well off. The prices of these products will hold up, but they will not compensate for the big increases in the price of imported grain-based foods and the increased cost of energy products.

The key role of central banks is to control price inflation., but their only policy tool is the interest rate, which they adjust to control the supply of money. This tool works for the first type of inflation listed above, although it does produce pain.

However, the tools of the central banks are totally ineffective against price increases that are caused by a serious economic shift like the war and sanctions that the world is currently experiencing. Adjusting targe interest rates cannot produce more oil or more grain.

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