Monday, April 27

Inflation: Causes, Diagnosis and Cures

The Bloomberg Commodity Index, a broad-based benchmark covering energy, metals, and agricultural commodities, is up at the moment. In the past this index has been correlated with periods of higher inflation.

Because of this relationship, it is worth looking at what inflation is, its causes and its cures.


What is inflation

Prices rise when demand for a good or service increases relative to its supply, or when supply decreases relative to demand. This is the basic mechanism. But a single price moving on its own is not inflation. Inflation is what happens when this mechanism is operating across many goods and services at once.

The textbook definition of inflation is a sustained increase in the general level of prices of goods and services. All three sets of bolded words in that definition are doing work. "Sustained" excludes once-off or temporary price spikes (e.g. a change in taxation arrangements for a good or service or a supply shock that quickly reverses). The "general level" means that quite a number of individual items are experiencing price rises at the same time, not one or two prices rising sharply while others stay flat. A rise in a particular price, such as oil, is a relative price change. It becomes inflation only if it spreads across the general price level. "Goods and services" indicates that inflation is primarily about the goods and services consumers use in their everyday lives. It excludes asset prices (such as land, stocks and bonds) as well as mortgage rates.

The historical record shows two related patterns worth holding in mind. First, prices very rarely fall on aggregate. Once the general price level moves up, it is uncommon in modern Australia for it to move back down. The deflationary episodes that were common before the Second World War are almost absent from the postwar Australian record. Second, while prices rarely fall, inflation rates rarely persist at elevated levels for long. Most high-inflation episodes are spikes that subside within a few years through some combination of supply normalisation, demand slowing, and policy response. The exception is genuine stagflation of the kind Australia experienced from the mid-1970s to the mid-1980s (and arguably, the early 1990s), where inflation became embedded in expectations and institutional arrangements and took more than a decade to break. Outside that exception, inflation episodes look like the early 1950s spike during the Korean War, or the late 2000s commodity peak, or the post-pandemic surge: discrete events rather than persistent conditions. The chart shows these as distinct peaks against a generally low background rather than as a continuously elevated band.


Inflation is how a market manages multiple shortages

Inflation is what the price system does when demand and supply more generally are out of balance at current prices. Prices rise to clear the imbalance, ration scarce goods to highest-value uses, and signal producers that there is profit to be made by expanding output. The price movement is not a malfunction of the system. It is the system working. Prices rise because supply is constrained relative to demand. The firms that raise prices are performing the function the price system exists to perform. The alternatives to price-based rationing are queuing, formal rationing, and quality degradation, none of which are obviously better. The inflation is uncomfortable but it is also how the economy adjusts to the underlying imbalance.

Price fixing is the policy version of these alternatives and it deserves direct treatment because it is the response most often proposed when prices rise sharply. Capping prices below the market-clearing level does not eliminate the underlying imbalance between supply and demand. It just suppresses the signal the price system was sending. The shortage continues but it now shows up as empty shelves, queues, or black markets rather than as higher prices. In the most extreme version, suppliers withdraw from the market entirely because they cannot cover their costs at the capped price, and the good simply stops being available. Producers who would have expanded output in response to higher prices have no reason to do so. Consumers who would have economised on the constrained good have no reason to do so. The misallocation that the price rise was correcting persists, and the political pressure for further intervention grows.

The historical record is consistent enough that it should settle the question. Wartime price controls in the 1940s required ration cards, queue management, and extensive enforcement against black markets. Nixon's wage and price controls in 1971-74 produced shortages, gaming, and a renewed inflation surge once they were lifted. Venezuelan price controls produced empty supermarkets in a country with substantial agricultural capacity, and in the most controlled categories producers stopped supplying altogether. Price fixing addresses the symptom while leaving the disease, and the symptoms it produces in place of inflation are usually worse than the inflation it was meant to prevent. There are narrow exceptions for genuine market failures or short-term emergency interventions, but as a general response to inflation it has failed wherever it has been seriously tried.


How much inflation: the Goldilocks problem

A small amount of inflation is not a problem. The consensus view among economists is that a low positive inflation rate, somewhere in the range of 2 to 3 percent, is actively desirable. The reasoning runs through several channels. A small positive rate gives the economy room to adjust relative prices without requiring nominal wage cuts, which workers and firms resist even when they would accept the equivalent real cut delivered through inflation.

Deflation, when the general level of prices is falling, is a much more serious problem than a small amount of inflation. When deflation occurs, households are encouraged to defer spending for a point in the future when the good or service will be cheaper. This discouragement reduces aggregate demand and lifts the unemployment rate. It becomes a self-reinforcing problem: deflation produces more deflation. Because of this problem, economists prefer a small positive inflation target over a zero target, so that the economy is unlikely to fall into deflation.

The 1930s in the United States and the 1990s in Japan are the canonical cases. Falling prices give households reason to defer spending, which weakens aggregate demand, which puts further downward pressure on prices, which gives households further reason to defer. The debt burden rises in real terms because nominal debts do not adjust, which produces bankruptcies and financial stress that further weakens demand. Central banks struggle to respond because nominal rates cannot fall meaningfully below zero. The Japanese experience of two decades of weak growth and persistent deflationary pressure shows how hard it is to escape this trap once it takes hold. The case for a small positive inflation rate is partly that it provides insurance against ever falling into a Japanese-style deflationary equilibrium.

Too much inflation is a problem because it imposes real costs on the economy. The price system stops conveying useful information when the general price level is moving rapidly, because firms and households cannot easily distinguish between movements in relative prices and movements in the price level itself. Long-term contracts become harder to write because nobody knows what the dollar will be worth in five years. Investment decisions become harder because the discount rates that should apply are themselves uncertain. The economy spends real resources adjusting to inflation that it could otherwise spend producing goods and services. These costs are diffuse but they are real, and they accumulate over years.

The deeper reason inflation matters is distributional. Inflation falls heavily on people whose income and wealth are in nominal terms with limited ability to hedge. Pensioners on fixed nominal incomes lose real value year by year. Low-income workers without indexation watch their wages lag behind prices. Savers without access to inflation-hedging assets pay the inflation tax in full. The wealthy and the indexed are partially protected. The poor and the unprotected pay the full cost. This is one of the most regressive transfers a modern economy can produce, and it operates silently year after year while everyone congratulates themselves on the absence of visible recession. Fighting inflation is not just a technical concern about price stability. It is a distributional concern about who bears the cost of monetary mismanagement.

So the goal is neither zero inflation nor high inflation but a small positive rate maintained consistently over time. The current Australian situation has inflation moderately above this target rather than dangerously high in absolute terms, but moderately above target for a sustained period is itself a problem because of how it interacts with expectations and because of the cumulative real income losses it imposes on the unprotected.


The Drivers

Inflation has five main drivers. Sometimes one is doing most of the work. Often several are running at once, and the diagnostic problem is identifying which combination is active in the current episode.

Constraints on global supply. There are commodities that every economy needs. Some of those Australia produces locally, others we must import. Nonetheless, all of them are subject to global forces of supply and demand. At the moment, the boom in artificial intelligence (AI) is increasing demand for commodities such as copper, silver and electricity. The war in Iran and the effective closure of the Strait of Hormuz have constrained the supply of crude oil, natural gas, diesel, jet fuel, helium, urea, sulphur and specialty chemicals. These global pressures result in higher prices for these commodities in Australia (even when Australia produces more than it needs). For a small open economy these effects are largely outside domestic policy control. The 1973 and 1979 oil shocks are the canonical examples. The 2021-22 episode produced similar dynamics through pandemic disruption. The current rise in the Bloomberg Commodity Index suggests this driver is active again. Whether it produces persistent inflation depends on the other factors.

Demand outrunning productive capacity. Typically when demand outstrips productive capacity, it is because there is too much money in the economy. This can happen through fiscal policy, when governments increase payments or reduce taxes. It can happen through monetary policy, when borrowing rates reduce, encouraging borrowing. It can happen if wage setting arrangements automatically pass on to wages any inflation that is seen in the general level of prices in goods and services. All three mechanisms put more dollars in the hands of people who will spend them, which is what generates the demand pressure.

While we are talking about too much money, it is worth engaging with Milton Friedman's claim that inflation is always and everywhere a monetary phenomenon. In terms of short-run inflationary spikes, the claim is false, as this list of potential drivers demonstrates. However, when it comes to sustained inflation, this always requires monetary accommodation. Without monetary accommodation, a rise in prices for one good must be offset by falls in prices elsewhere. As a result, the general price level remains unchanged. There are two points of monetary accommodation. The first is the central bank. The central bank accommodates by keeping its policy interest rate low, which expands borrowing and spending. It resists by raising the policy rate, which reduces the effective money supply and slows demand. The second is the method used for setting wages and government payments in response to an increase in general prices. Wage indexation accommodates by automatically expanding nominal wages in response to higher prices. It resists by holding wages stable when prices rise, which forces the price rises to be absorbed in real income rather than passed through into the next round of wage and price setting.

Currency depreciation. For a small open economy with substantial commodity trade and a floating exchange rate, currency movements transmit inflation independently of world price movements. The 1985-86 Australian dollar collapse imported inflation through this channel. Recent episodes have done the same on smaller scales. A weak currency that fails to reflect favourable terms of trade amplifies whatever supply pressure is coming through global commodity prices. This factor operates alongside global supply rather than as a subset of it, because the same world price movement produces different domestic inflation outcomes depending on whether the currency is appreciating, stable, or depreciating.

Expectations. The persistence of any given inflationary impulse depends substantially on whether households and firms believe the central bank will bring inflation back to target. Anchored expectations dampen second-round effects because workers do not demand inflation-matching wage rises and firms do not pre-emptively raise prices in anticipation of future inflation. Unanchored expectations turn one-off shocks into sustained inflation through a wage-price feedback loop. Central bank credibility is the main determinant of how well anchored expectations stay during periods of stress. This is why the same shock can produce very different inflation outcomes in different countries. The shock is exogenous. The response depends on what people believe about the institution responsible for managing it.

Institutional transmission. The wage-setting system, pension indexation arrangements, the degree of competitive pressure in product markets, the openness of trade, and the financial system's transmission of monetary policy all determine how rapidly cost pressures convert into sustained inflation. Tight transmission converts shocks rapidly into persistent inflation. The Australian experience of the 1970s, with formal wage indexation and a closed protected economy, is the canonical example. Loose transmission allows shocks to dissipate. The Australian economy of 2026 has substantially looser transmission than the economy of 1976, which is the main reason why the post-pandemic inflation episode has not become entrenched the way the 1970s episode did.

These drivers do not operate in isolation. A supply shock that arrives during strong demand has different consequences from the same shock during weak demand. A currency depreciation when expectations are anchored has different consequences from the same depreciation when expectations are drifting. The drivers interact, and good diagnosis has to track the interactions rather than just listing the contributions.

There is also a methodological point worth surfacing. The diagnosis depends on the framework used to do it. A monetarist framework will tend to find demand drivers wherever there is monetary expansion. A neo-Keynesian framework will tend to find demand drivers wherever there is an output gap. A supply-focused framework will tend to find supply drivers wherever there are commodity price movements. A heterodox framework will tend to find market power drivers wherever there are concentrated industries. Each framework is partly right and partly wrong, and the practitioner who uses only one will systematically misdiagnose episodes where the dominant drivers are outside that framework's preferred category. Good diagnosis requires holding multiple frameworks simultaneously and using each to test the others.

This is the central skill of monetary policy and it is what makes the job hard. The Reserve Bank looks at the inflation reading, diagnoses the underlying drivers, considers the time profiles and interactions, anticipates how its own response will feed back into the system, and chooses a policy stance that responds to the most likely diagnosis while remaining alert to the possibility of being wrong. The diagnosis is not directly observable. Different observers using different frameworks will reach different conclusions from the same data. Public debate that skips this step and argues about response without specifying what is being responded to is missing the analytical step that determines whether the response is appropriate.


The Cures

The standard tool of monetary policy is the policy rate. Raising it reduces demand pressure, supports the currency, signals credibility to expectations, and dampens institutional transmission by making wage and price increases harder to sustain. Lowering it does the opposite across all channels. The Bank cannot tighten on one driver without tightening on all of them. The choice of policy stance is a single choice that has to balance the diagnostic profile of the current episode.

Supply-driven inflation that is genuinely transitory should be looked through. Tightening into a fading shock adds unnecessary unemployment without producing inflation gain. The textbook answer is to let the shock pass through, accept the temporary bump in headline inflation, and keep policy focused on the underlying trend. Central banks distinguish headline inflation, which is the full price change including volatile components, from underlying or core measures that strip out the most volatile movements. The Reserve Bank's preferred underlying measures are the trimmed mean and the weighted median, which exclude the largest price movements in either direction each quarter rather than excluding fixed categories like food and energy as the US Fed's core measures do. The advantage of the trimmed mean is that it is less noisy than headline CPI, which gives a more reliable view of where inflation is actually running. Looking through transitory shocks means responding to underlying inflation rather than headline. This works only while expectations stay anchored. The moment long-run expectations start drifting, looking through becomes the mistake that lets the shock become entrenched.

Supply-driven inflation that is persisting requires monetary tightening to prevent expectations from drifting. Persistent supply pressure compounds in ways that transitory shocks do not. The level chart of commodity prices shows the post-pandemic environment is different from the post-2014 disinflation, and continued upward pressure from global supply suggests a sustained shift rather than a transitory shock. The look-through approach that worked in the 2010s may not work in the 2020s.

Demand-driven inflation requires tightening calibrated to the demand-supply gap. This is the textbook Taylor rule case. The Taylor rule, named for the economist John Taylor, says the central bank should set its policy rate by reference to two gaps: actual inflation against the target, and actual output against capacity. When inflation runs above target, the rate should rise. When output runs above capacity, the rate should rise. When both run above, the rate should rise more. The key insight is that monetary policy should respond systematically to observable conditions, and that the response should reflect both the inflation problem and the output problem rather than treating either in isolation. The current Australian situation has inflation moderately above target but the demand-supply gap is contested. Different observers will read it differently depending on how much weight they place on labour market tightness versus output gap measures versus financial conditions.

Expectations problems require aggressive action to demonstrate central bank credibility. This is the Volcker case. Once long-run expectations have unanchored, the only way to bring them back is through demonstrative action that imposes real costs and proves the central bank means what it says. The 1979-82 episode in the U.S. is the canonical example. Australia has not been in this situation since the early 1990s and the current episode does not require it. But it is the situation the Bank is trying to avoid through earlier and smaller action now, because the cost of letting expectations unanchor is much larger than the cost of tightening pre-emptively.

Currency-driven inflation requires either tighter monetary policy to support the currency or acceptance of the imported pressure depending on the domestic outlook. A floating regime gives the central bank flexibility but also creates the risk that exchange rate movements transmit inflation without any domestic shock. The Australian dollar weakness despite favourable terms of trade is amplifying the imported component of inflation in ways that complicate the Bank's response.

Institutional transmission problems require structural reform that the central bank cannot deliver alone. This is the case where monetary policy has the least to offer. If wage indexation or product market concentration is converting shocks into persistent inflation through automatic mechanisms, the appropriate response is to reform the mechanisms rather than to tighten until the inflation breaks. Australia's experience between 1975 and 1995 demonstrates how slow this kind of reform is and how much inflation persists during the transition.

Monetary policy operates with long and variable lags. A change in the policy rate today affects demand and inflation over the following twelve to eighteen months, and the size of the effect varies with the state of the economy, the level of household debt, and the expectations of borrowers and lenders. The Bank is therefore always setting policy for conditions that do not yet exist, using forecasts that are themselves uncertain. This is part of why diagnosis matters so much. By the time the inflation reading confirms the diagnosis, the policy that should have responded to it was needed a year ago.

The asymmetry of error is worth surfacing because it justifies the Bank's current bias. Under-tightening lets inflation become entrenched, and the longer it runs the more expensive the cure. Australia learned this the hard way. Most comparable economies broke the 1970s stagflation in under a decade. Australia took almost twenty years and two recessions (the first one was wasted) with unemployment above 11 percent. Over-tightening produces a recession that is recoverable. Under-tightening eventually produces one that is not optional. Given that asymmetry, erring toward tightening when the diagnosis is uncertain is the right bias. This is the logic behind the recent rate increases. The case is not that current inflation requires them. It is that the cost of being wrong in the loose direction is larger than the cost of being wrong in the tight direction.

There is also the question of what monetary policy cannot do. It cannot grow more oil or unblock the Strait of Hormuz. It cannot legislate productivity growth. It cannot reform wage-setting institutions. The instruments are blunt and the targets are limited. Public debate routinely expects more from central banks than monetary policy can deliver, and central bank communication that fails to set realistic expectations leaves the institution carrying political weight it cannot bear. The honest version of the Bank's position is that it can keep expectations anchored and prevent supply shocks from becoming entrenched inflation. It cannot prevent the shocks themselves and it cannot make the resulting real income loss painless.

Central banks are also not the only institution with a role. Fiscal policy affects aggregate demand directly, and a government running a loose fiscal stance into an inflationary episode forces the central bank to tighten harder than it otherwise would. The burden of disinflation then falls disproportionately on interest-rate-sensitive sectors, particularly housing and business investment, while government spending continues to add to demand. Coordinated tightening, where fiscal policy supports rather than offsets monetary policy, distributes the adjustment more evenly and reduces the total economic cost. Governments that leave the inflation problem entirely to the central bank are choosing a worse outcome than necessary.


Diagnosis Before Cure

The point this post is making is methodological as much as substantive. Inflation has many causes, and a public that argues about cures without diagnosing causes will get the response wrong systematically. The framework above is not a definitive answer to any current policy question. It is a way of organising the diagnostic work that has to come before the policy answer.

The current Australian episode has a specific diagnostic profile. Headline inflation is moderately above target. Long-run expectations are holding. Short-run expectations are drifting at the edge of the band. Commodity prices are elevated and rising. The currency is weaker than terms of trade alone would justify. Productivity growth is weak. Wage growth has been restrained but is at risk of accelerating if expectations continue to drift. The institutional transmission is looser than in the 1970s but tighter than the textbook open economy case.

This profile points toward modest tightening as the appropriate response, which is broadly what the Bank is doing. The case is not that inflation is dangerously high right now. The case is that the combination of supply pressure, currency weakness, and expectations at the edge of the band creates real risk of a worse outcome if the Bank does nothing. The asymmetry of error favours acting now rather than waiting for the diagnosis to become unambiguous, because by the time it is unambiguous the cure is much more expensive.

Other observers reading the same data through different frameworks will reach different conclusions. That is the nature of the diagnostic problem. The point is not to insist on this particular diagnosis but to insist that the diagnostic step is where the analytical work happens, and that arguments about cures that skip this step are arguing about the wrong thing.

If there is a single takeaway, it is this. When you read commentary about inflation, ask which drivers the commentator is implicitly assuming are doing the work. If the commentator does not specify, the commentary is probably not helping you understand what is happening. If the commentator specifies but does not consider the alternatives, the commentary is probably not helping you understand what could go wrong with the diagnosis. Good inflation analysis is honest about the diagnostic uncertainty and explicit about the framework being used. Most public commentary fails both tests, which is part of why public debate about inflation tends to generate more heat than light.


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