Rising costs to bite diners

Economic models are far from perfect for any one nation, and there are many regions and nations with (imperfect) economic interconnections that are far too complex for anyone to unravel. Hence Adam Smith's famous "invisible hand" analogy.

But here's the rub.

If factors particular to particular markets force some prices up, either other prices must fall, or the overall level of prices must rise - the latter outcome is defined as "inflation".

In theory, a wise and benevolent central bank can keep strict control of the money supply so that average prices do not change - i.e. inflation is, on average, at zero. In practice this is a far from perfect science so mistakes occur, as occurred leading up to the current global inflation of average goods and service prices. But there is a deeper problem.

The process of inflation works less smoothly in reverse, when deflation is required. The most famous example is probably UK in the 1920s. During World War I Britain abandoned the so called "gold standard". Then in 1924 the Chancellor, Winston Churchill, returned Britain to the gold standard of the pre-war value of sterling in relation to gold. But in the meantime many prices had risen, including the wages of various classes of British labour.

To restore full employment, wages (and many other prices) would have had to fall but these prices refused to fall, or fell only slowly. The net result was economic depression, high unemployment, and many severely disadvantaged families whose bread-winners were unemployed.

Recognition of the "stickiness" of many wages and prices, especially in a downward direction, led the economics profession to develop a bias for mild inflation. Australia's "target range" for inflation is 2 to 3 per cent, partly in recognition of the effect of sticky prices and partly because of the more technical matter that existing measures of goods and services inflation are believed to understate effects of improvements in the average quality of goods and services.

Mild goods and services inflation is widely believed to be the best outcome. But inflation is influenced by the expectations of people as well as the objective setting of monetary policy. Most people can immediately grasp that a too loose monetary policy might lead to inflation, and some people seeing loose money immediately adjust their expectations about inflation and this leads almost immediately to greater inflation. This double whammy is likely to intensify as public discussion of inflation, including newspaper reference to inflationary expectations, gains popularity.

In practice, mild inflation often turns into serious inflation. Serious inflation is very damaging. The risks of this are especially high when particular special factors are raising sharply the prices of some goods and services - such as food, petrol and interest rates at present. For the central bank to keep overall inflation "mild" it must keep monetary policy firm and rely on this to force down sharply the prices of other goods and services, or indeed, of assets.

Owners of other goods and services, or assets, resist price falls and complain loudly to the government. So do - and with greater cause - those people suffering from the direct effect of rising prices of food, petrol and interest rates.

All this is why Australian economic policy, and especially monetary policy, is in such an interesting state.