Inflation - serious illness of mismanaged economies

Inflation is a serious illness of mismanaged economies. To stop inflation in Australia now requires resolute action. The Reserve Bank should announce a 50-basis-point rate hike today. The costs of inflation are understood by the Rudd Government, which is why curing inflation is its No1 priority.

There are three varieties of inflation - demand-pull inflation, cost-push inflation and expectational inflation. Expectational inflation is a secondary infection, which builds upon and reinforces primary inflation whether based originally upon excess demand or cost push.

Inflation is building globally. China's consumer price inflation continues to rise - to 7.1 per cent on the latest measure. US consumer price inflation hit 4.3 per cent in the year to January. The latest reading of US producer price inflation was 7.5 per cent, highest for 26 years. A measure of US inflation expectations says it has risen in the past year from 2.2 per cent to 3.4 per cent, the highest in a decade.

Globally, gold futures recently hit a new record, the price of oil hit new highs above $US100 per barrel, coal prices are very strong, iron ore is up by 65 per cent and the prices of various foodstuffs are rocketing. And, to greatly compound the problem in the US, indicators of activity, most recently manufacturing activity, are indicating a slump, probably a recession.

Inflation with a slump in activity is called stagflation. It is the result of cost-push inflation. The US is suffering from cost-push inflation, as witnessed by growing producer price inflation, compounded by inflationary expectations.

US Fed chief Ben Bernanke has denied the US is entering a period of stagflation, but Henry assumes he is trying to limit downside damage to activity and upside damage to inflation expectations.

China is suffering from a mix of cost-push inflation - think iron ore, coal, steel and oil - but also demand-pull inflation. China's consumers and producers must be building in expectations of rising inflation. This is the point at which inflation becomes self-generating, and far harder to stop.

Old hands will recall that the start of serious inflation in the early 1970s here was said by some to be due to inflation in the prices of potatoes and onions. Then Treasury said the problem was wage-push inflation. Only the Reserve Bank got the diagnosis right.

The truth was that Australia was importing inflation from an inflationary world. Global inflation originated in the US with great increases in government spending. President Lyndon Johnson was fighting two wars - on poverty at home and communism in the jungles of Vietnam. Then the prices of oil and other raw materials spiked up and global inflation was out of control.

Australia imported global inflation - essentially a variant of demand-pull inflation. Then the Whitlam government added its own "Great Society" spending to worsen the problem and wage costs ballooned as domestic costs accelerated. Inflation expectations exploded upwards and the economy was for a time virtually out of control.

The Reserve Bank got the diagnosis right, but lacked the tools to effect a cure. The exchange rate was fixed (lurching up and then lurching down in ways that greatly exacerbated both the illness and the side-effects). The financial system was highly regulated and interest rates were not allowed to rise to stifle excess demand. And it was Mr Whitlam who was in control of monetary policy, not an independent Reserve Bank governor. The governor could (and did) advise "till he was blue in the face", but corrective action was too little, too late.

Now the tools to control inflation are in place in Australia and the US. However, in China and other developing nations the situation is far more like the one Australia had in the early 1970s.