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.

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.

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.