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Inflation - serious illness of mismanaged economies

By Henry Thornton - posted Tuesday, 4 March 2008


The Chinese exchange rate is crawling up and cannot flex sufficiently to ward off imported inflation. China's financial system is rigid and interest rates cannot flex sufficiently to dampen domestic excess demand. China's central bankers have undoubtedly diagnosed the situation correctly, but their views have perhaps less chance of persuading the politicians than the Reserve Bank had in Australia in the early 1970s.

Looked at in this global framework, Australia is in an unhappy situation. Activity is slowing in the US, while inflation is rising. In China, both demand-pull inflation and cost-push inflation are rampant, and dispassionate analysis must doubt China's ability to impose control over inflation without a significant downturn.

Here is the rub. Inflation, once it takes hold, is impossible to stop without a serious check to activity. The inflation of the 1970s was stopped in the US in the early 1980s by a courageous central banker, Paul Volcker. This required a "short sharp monetary policy shock". The surprise was the speed with which inflationary expectations adjusted down, not the severity of the recession.

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Australia took another decade to abandon attempts gradually to resolve its inflationary problem. When it did steel itself for decisive action, the short sharp shock was apparently partly accidental - recall "the recession we had to have".

The Rudd Government has inherited an economy with the inflationary sickness taking hold. Excess demand inflation has been steadily building, with a couple of quarters of lower numbers to confuse the Reserve Bank at a time when it should have imposed tougher monetary policy, including at least one pre-emptive 50-basis-point tightening.

"Too little, too late" again, despite the improvements to the technical and political framework.

Inflationary expectations have started to rise, skilled labour is in short supply, labour costs are rocketing in the booming resource states, health and education workers are restive throughout the nation. The puzzle for some is that so far we have not seen a general surge of cost-push inflation.

The Rudd Government has backed the Reserve Bank to the hilt, and has devised its own "five-point plan" to curb inflation. This plan includes building skills, fixing infrastructural bottlenecks and cutting government spending. These actions may have some effect in containing inflationary expectations. But they will have very little effect in reducing excess demand inflation and they will have no effect in containing cost-push inflation.

There is only one sensible conclusion to this dilemma. The cost of resolute monetary policy tightening now will be far less than the costs if monetary policy action continues to be too little, too late.

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First published in The Australian on March 4, 2008.



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About the Author

Henry Thornton (1760-1815) was a banker, M.P., Philanthropist, and a leading figure in the influential group of Evangelicals that was known as the Clapham set. His column is provided by the writers at www.henrythornton.com.

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