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  • Writer's pictureFinnegan Collins

Inflated Expectations

Updated: Oct 13, 2021

Why has money supply increased? Why was CPI negative during June 2020 even though we should have experienced rampant inflation?

Milton Friedman once said “Inflation is everywhere and always a monetary phenomenon.” . Tell this to the Australian economy. By some measures, the money supply has increased by 50% in the space of two years. The Australian government’s forecasted debt is expected to be $700 billion. This has all occurred during a pandemic, which has battered supply chains and disrupted a services sector that accounts for 80% of the Australian economy. According to traditional economic orthodoxy, this should be fertile ground for rampant inflation. Yet in June, CPI was negative. In December, this figure had rebounded to only 0.9%.

This has partly been due to business innovation and adaptivity. This is reflected in an unemployment rate (6.6%) that is well below the RBA forecast, even given fiscal support. International supply chains remain sturdy, with imports and exports remaining mostly stagnant. As a result, a supply shock has been largely avoided. Furthermore, although the central bank has taken unprecedented action to expand the money supply, the reticence of commercial banks to lend has dampened velocity, and thus inflation. This is reflected in the lack of growth in M3, a broader definition of money that incorporates less liquid assets that arise from bank lending. Macroeconomists perceive M3 as a stronger predictor of inflation, and this figure has only risen 15% over the last two years. While high historically, this is lower than expected given such aggressive expansion of the money supply by the central bank.

Other reasons for low inflation are directly related to the pandemic. Although Australia has contained the coronavirus more effectively than many similar industrialised economies, the savings rate remains stubbornly high. The latest figures peg the Australian savings rate at 18.9%. This is higher than the corresponding figures for the US (13.9%) and UK (16.5%). The housing market has also seen a significant cool off. As the highest weighted item in the CPI basket (22.7% weighting), this has an outsized impact on inflation. This has been primarily driven by uncertainty, but the influence of an increased exodus from the city cannot be discounted, catalysed by the new flexibility that has arisen from online work.

The apparent disappearance of inflation worldwide over the past decade has impacted the perception of monetary policy among central bank officials internationally. Back in September, Fed Chair Jerome Powell introduced a policy of Average Inflation Targeting (AIT), breaking from decades of fixed inflation targeting. This gives the Fed more discretion, especially given the chronically low inflation of the 2010s. A recent poll by CEPR, a policy think-tank based in Washington, found that only 14% of surveyed British macroeconomists thought that monetary policy was the greatest inflationary force facing the UK economy.

The RBA looks to follow suit. The increased activity in the corporate bond market more acutely risks inflation, as this directly influences M3, unlike more traditional monetary policy actions. In March, a yield target on three-year government bonds was announced. Just this month, the RBA released it would undertake another $100 billion in bond purchases after April. For each of these policies, there are speculators that insist that this is the straw that will break the camel's back. Whether inflation’s current elusiveness will actually remain the status quo remains to be seen.

By Finnegan Collins - 2nd Year Bachelor of Science and Bachelor of Advanced Studies (Financial Mathematics and Statistics & Economics)

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