If, for whatever reason, we ramp up our spending to an excessive level, say as Australians prepare for Christmas, inflation will rise. The reasons for excessive spending can be due to the fact we have plentiful savings, our level of wealth has risen, pay rises are common and large or we have an ability and willingness to borrow lots of money, to name a few.
Excess spending can lead to high inflation because the businesses we go to when we splash our cash see that their sales are strong. As a result, they will try to – and usually succeed – in putting up their selling prices without there being any loss in sales, such is the consumer exuberance and willingness to spend.
We consumers don’t mind paying the extra price businesses charge because we are feeling flush with cash and need to satisfy our demand for the goods and services on offer.
In these circumstances, which lead to high inflation, the Reserve Bank (RBA) will respond by hiking interest rates to dampen consumer optimism and spending as we allocate more cash to servicing debt.
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It is noteworthy that inflation can also rise because the cost of business inputs rise – materials, rents, wages and even interest rates can add to the cost of running a business. For a firm to retain its profitability in these circumstances, it has to pass on these higher prices to consumers to remain solvent. A firm cannot stay in business for very long if its costs exceed its selling prices. And no one wants that.
Lower demand lowers inflation
In terms of the first cause of inflation - excess demand - the purpose of higher interest rates is to force consumers to scale back their spending and to boost their savings.
For the roughly one-third of households with a mortgage, higher interest rates divert their cash flow towards interest payments and servicing their debt, which means less can be spent more directly in the economy. High interest rates also make it more attractive for those with savings to earn a higher interest income.
It is always a difficult judgement for the RBA and markets to know what level of interest rate is effective in dampening spending to the exact extent that sees business scale back price increases and offer discounts without too much in the way of collateral damage in the form of higher unemployment.
For the current cycle, there is no doubt the 400 basis points of interest rate hikes delivered by the RBA between May 2022 and June 2023 are biting and that consumers are scaling back their spending. Retail sales are weak, the broader measure of household consumption is also falling in per-capita terms, suggesting that the average volume of goods and services being consumed is also falling.
In an ideal world, consumers would cut their spending in an altruistic manner, without the heavy hand of the RBA imposing severe increases in interest rates.
Alas, many decades of history shows that never happens. It requires a tightening in economic policy, usually in the form of higher interest rates.
At one level, if we consumers collectively and voluntarily scaled back our level of spending, it would lower ‘demand-driven’ inflation pressures.
That said, it is hard to see that happening without the heavy hand of a tightening of economic policy forcing us to act.
It is also difficult to see how such a call to action would work.
Could the government undertake a ‘cut your spending’ advertising campaign in much the same way it marketed its ‘stop smoking’ strategy? It seems unlikely this will ever happen or work.
While this remains the case and consumers universally act in their own self interest, it will be economic policy that forces us to cut growth in demand and, with that, trim inflation pressures.