22 Feb 2022

What is the Cause and Remedy for Inflation?

By Jussi Ora

An important and hot topic with regards to the monetary system is inflation. If we want to reduce inflation and the risk of it in the longer term, we need to be clear about its causes. As well as the consequences of how we choose to deal with it.

Inflation is a general increase in prices and is measured by changes in the annual Consumer Price Index (CPI). The CPI is the price of a basket of goods and services that the average consumer is assumed to consume. An increase in a single price is not inflation, but the price of many goods must increase continuously over time for it to be inflation.

Inflation is said to occur when demand exceeds productive capacity. There are different approaches to handle this excess, each with its own effect on the economy. Today’s approach is focused on reducing demand. Demand can be reduced by increasing unemployment, which dampens wages, purchasing power and investment. The idea is that fewer people will be able to afford to have their needs met, thereby ensuring the quality of life of the rest by achieving the inflation target. The result is increased inequality.

“This means the Fed will battle inflation the old way – drafting millions of workers into the inflation fight by slowing the economy and causing them to lose their jobs or wages, or both.”

This is the wrong medicine for the wrong disease. It will hurt millions of people who are among the most vulnerable in the economy. The correct medicine is to reduce corporate market power.”

Robert Reich

Another alternative approach to handling inflation is to focus on production capacity and abuses of market dominance where companies raise prices just because they can. Inflation is dealt with partly by investment in increased productive capacity and partly by regulations that prevent the abuse of dominant position. Professor Fadhel Kaboub discusses this in this interview, starting from the premise that the goal is prosperity for all. He also raises the cost of doing nothing about societal problems, which in itself is linked to austerity.

How the macroeconomy is managed matters a lot. Interest rates have been erroneously seen as the most important means of managing the economy, of controlling inflation. This blind-sided focus is still the main policy action used today, despite decades of failure by the world’s central banks to achieve their inflation targets.

The Swedish central bank, Riksbanken, writes. “In order to achieve this target [inflation 2 per cent, my addition], the Riksbank raises or lowers the policy rate (repo rate). The interest rate is the price of money, so by raising or lowering the interest rate we influence the demand for money in the economy.”

We need to think about how interest rate hikes deal with inflation if they are due to broken supply chains, shortages of inputs, high energy prices, companies abusing their market position and raising prices because they can, etc.? How is inflation managed by cutting the public budget and raising the cost of capital (interest), in both the short and long term?

What interest rate policy has succeeded in doing is driving up the prices of financial assets and housing. For owner-occupiers, lower interest rates mean they can take on more debt for the same monthly cost. Simplified, without repayments and interest deductions, this example shows the connection: with a debt of three million at 4% interest, you have a monthly cost of 10 000 SEK. When the interest rate is reduced to 2%, the monthly cost is the same with a debt of six million.

At the same time, we have a situation where the production capacity to build new housing is much lower than the demand. This increases the willingness to, and forces, increased indebtedness. We need somewhere to live, that is important, and therefore we will bid up prices to the limit of what we can afford. Because the pressure is greatest in the big cities, the jobs are drawn there, prices will be highest there. This has been the case for many years, and it leads us to believe that prices will hold up over time. It also means that we dare to take on more debt.

Here is an example from Sweden. Over the past 20 years, housing debt has increased by an average of 8.1% per year. In December, the sum of these were 4 468 billion (equivalent to about 89% of GDP). Raising interest rates by one percentage point would increase costs by 44,6 billion, and by two percentage points it would mean 89,2 billion (before interest deductions). This is one of the reasons why it is said that the Riksbank finds it difficult to act by raising interest rates. It would significantly reduce aggregate demand in the economy and tax revenues for municipalities and regions. If housing prices are affected by interest rate rises, things could get even worse. In the worst case, a housing crash and banking crisis. Professor Richard Werner concluded in his empirical research that interest rates do not work to control the economy.

Those who stand to gain from interest rate rises are financial players who speculate that it will be raised, who have taken positions for it in the market. Likewise, those who have enough money to buy in a crisis where various assets fall in value.

More on inflation and how monetary reform can decrease societies co-dependency to financial speculation in forthcoming newsletters.

Jussi Ora
Positiva Pengar