Can a sustainable inflation rate be achieved?

May 19, 2020
Editor(s): Jiamin Fang
Writer(s): Nuoya Liu, Richard Yuan

For several years now, the Federal Reserve in the United States and the Reserve Bank of Australia (RBA) have been trying to keep a low and steady level of inflation, which is perceived as a symptom of an improving economy. While the Federal Reserve has a target inflation rate of 2%, the desired level of inflation falls anywhere between 2-3% for the RBA. Both central banks were reluctant to be overly aggressive in their approaches to changing inflation in the past, due to concerns of overshooting their targets.  

In recent years, despite the strong economic performances in both countries prior to the pandemic – the US had experienced a booming job market while Australia had enjoyed 28 years of unbroken economic growth – the general level of prices has not risen significantly. In other words, neither country seems to have been able to maintain a sustainable and healthy level of inflation.

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For the US, inflation rates were higher in January 2017 (2.7%), April 2018 (2.9%), and February 2020 (2.5%) but fell significantly below the target in April 2020 to 0.3%. The higher inflation in January 2017 can be attributed to the 4.6 percent rise in prices for inpatient hospital care and the 6.1 percent rise for prescription drugs. On the other hand, the unusually low inflation rate of 0.3% in April 2020 was due to the government’s response to the COVID-19 crisis. In particular, stores have been restricted from opening and the demand for goods and services fell dramatically. The lower gasoline, clothing, and transportation prices also contributed to the plunge in inflation, despite higher food costs.

Similarly in Australia, the inflation rate has remained around 1-2% since 2015, slightly below the target of 2-3%. Noticeably, inflation has shown a steady decline since 2018 and is estimated to reach approximately 1.4% in 2020. However, inflation is forecasted to rise to 1.8% in 2021. In fact, many analysts are now saying that after several years of hovering below the inflation target, the RBA may finally see rates rising to or even above the 2-3% target.

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This is largely due to the series of expansionary measures that have been introduced in both the US and Australia. The RBA has cut its official interest rate to 0.25% after an out-of-schedule policy meeting. Before this, it had already lowered the cash rate to 0.5% at its February meeting. The act was primarily driven by the need to blunt the economic fallout from the COVID-19 pandemic. Fiscal policies have also been largely expansionary. So far, a $320 billion economic support package has been announced by the Australian government to support affected workers, businesses, and the broader community during this difficult time. Likewise in the US, the Federal Reserve cut rates twice in March, once by 0.5% and a second time by 1%. This means that the fed funds rate was lowered from 1.5%-1.75% to 0%-0.25% – a remarkable act considering that the Fed hasn’t moved interest rates in increments greater than 0.25% since the Great Recession. The US government has also passed fiscal stimuli worth $2.8 trillion, including three main relief packages and one supplemental one. Overall, aggregate demand is expected to rise in the near future, leading to demand-push inflation in both countries.

However, this seemingly long-awaited healthy inflation is yet to be the ultimate ending of the story. Indeed, economists have been closely monitoring the recent trends in consumer price index as many fear that the inflation rate may far overshoot the central bank’s target. This concern first attributes to what has been commonly referred to as the “3Ts” – trade, technology, and titans –, against which we have witnessed a sharp backlash as a result of Covid-19 and the following economic shutdown. As pointed out by Chetan Ahya, the chief economist at Morgan Stanley, “taken together, the policy actions … are more likely than not to result in a significant distortion of underlying productivity growth trends.” In an extreme case where the disruptions in the 3Ts create a regime shift in corporate profitability outlook, the inflation could quickly transit into a malign form.

It has also been contemplated that the Fed and government may adopt more deliberate pro-inflation policies to make their way out of this rapid increase in public debt. That is, following the announcement by the Treasury Department earlier this month to launch a new 20-year bond worth of $54 billion, the US national debt passed $25 trillion for the first time in history and is likely to continue moving upwards as Washington commits more money to rescue efforts. “The Treasury’s plan to issue more long-term debt is sensible enough when long rates are at ultra-low levels, but a more marked shift in debt issuance policy could signal that policymakers are hoping to engineer a rise in inflation to help bring the ballooning government debt burden under control,” Paul Ashworth, chief U.S. economist at Capital Economics, said in a note. This idea of inflating out of debt arises from the current low-cost environment, as buying debt with longer durations effectively keeps the yields fixed at a lower rate. On top of that, engineering an unexpected increase in inflation also reduces the real burden of the Federal debt by boosting nominal GDP and hence the tax revenues to pay down that debt. However, in the meantime, the current excessive borrowing by the government, when competing with the private sectors’ need on loanable funds, may also create excess demand in the market and hence lead to more expensive financing costs.

That being said, it is also contended that the inflation concerns are over-exaggerated since ‘the economy grapples much more with a demand drought that will exert lower price pressures’. Indeed, due to the surge in jobless claims and widely spread a sense of financial insecurity, national consumer spending has dropped to a record low as revealed by Trading economics’ data.

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This counterbalancing effect may as well place a higher level of uncertainty upon the trends and magnitudes of the future business cycle.


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The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.

Meet our authors:

Jiamin Fang
Nuoya Liu
Richard Yuan