Tighter Monetary Policy Is What’s Transitory

Tighter Monetary Policy Is What’s Transitory

Once again, Australia is proving to be the lucky country. While the rest of the world is caught up in an inflationary nightmare, prices Down Under are merely uncomfortable.

Of course, there are signs of trouble here too. Those trying to buy a car or home, for example, are finding it tough.

Rents are spiking too, reported by the Australian Financial Review:

House rents in some of Australia’s capital cities have risen between 15 and 20 per cent during the past 12 months.

I’m not sure where people are supposed to live at this point. Nor how they’re supposed to get there, given the waiting times on cars…

But compared to the rest of the world, we’re still much better off.

For how long, though?

And exactly how will the crisis catch up to Australia?

Part of the answer will be that our Reserve Bank of Australia has been given time to learn the lessons learned the hard way overseas. The Reserve Bank of New Zealand is trying — it just hiked interest rates twice as much as expected.

Central bankers are trying to go from being behind the curve to catching up with inflation. Australia and New Zealand’s — because of lower inflation and higher rates — are not as far behind as other central banks.

Interest rate hikes also move currency markets. Higher interest rates attract capital. And this moves up your currency. The result helps to rein in inflation by making imports cheaper too.

So perhaps there’s still a chance of escape for the lucky country, just as we escaped 2008.

But it’s important to remember what Austrian economist Ludwig von Mises told us in 1979:

The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy.

His point was that it’s deliberate. It is imposed on us.

The idea of the policy — known as financial repression — is to inflate away the government’s debt. It’s much easier to repay that debt if the dollar it’s denominated in isn’t worth very much.

This is why money was backed by something — historically speaking, gold. It allowed people to evade the prospect of financial repression by demanding what their money was backed by.

And politicians understand this distinction perfectly well. The recipients demanded Weimar Germany repay in goldmark, not papiermark (paper marks) after all, so no amount of hyperinflation could help Germany escape. (They have no excuse for what they did.)

But what politicians demand of each other is very different to what obligations politicians place themselves under. And so, today, central bankers are acquiescing to cause inflation to make their masters’ debt worth less.

The problem is, ‘worth less’ can quickly become worthless, as Weimar’s central bankers found out the hard way.

And inflation is incredibly difficult to rein in once it gets started.

Ironically, the way to rein in inflation (interest rates) is also the way to make sure the government’s debt gets inflated away. After all, your debt only becomes worth less if lenders don’t demand higher interest rates to compensate them for inflation.

But why would people lend money to the government at rates of interest below inflation?

Well, they usually wouldn’t. But central banks peg interest rates down low by buying government bonds. They do this to fund the government and to make sure that the only rates on offer from the government are low.

The RBA had promised this very policy. But the inflation spike put an end to that…

Notice how inflation can only be brought under control by the same interest rates that must be kept low to make financial repression work?

This is the trade-off that central bankers face. They can either allow an inflation crisis or trigger a debt crisis. They can either keep interest rates low to allow financial repression by way of inflation, or they can rein in the inflation with higher rates, leaving governments and other borrowers with unsustainable debt burdens.

If you see the world this way, as I do, then it explains why central banks were so reluctant to recognise inflation. If it was their policy to inflate away debt without causing a ruckus in the bond market, then they had to pretend it was transitory.

But bond investors are only so stupid. And so, the central banks’ presumptions about inflation have continuously shifted over the past few years. From ‘there will be no inflation as a result of QE’ to ‘it’s just the pandemic’ to ‘it’s just supply chain issues from lockdowns’ to ‘it’s transitory’ to ‘uh-oh’. ‘Putin’s price hike’ is just the latest one — another chance to ignore inflation.

The markets and the central bank meeting minutes now suggest an epic tightening of monetary policy to bring inflation under control. But is that really plausible?

Historically speaking, there are episodes when central bankers allowed inflation to spiral out of control, and there are episodes when central bankers were willing to trigger a debt crisis to rein it in.

I’m not sure what they’ll choose. But I don’t think the debt crisis route is far away if they do raise interest rates.

If you believe that just as central banks engineered inflation, they now seek to engineer an economic slowdown to bring it back under control, then you need to realise how this mechanism actually works.

History tells us that it isn’t just monetary tightening that brings inflation back under control, after all. It’s the recession that the tightening causes.

But a recession also allows central bankers to return to their loose ways again…

The only fly in the ointment would be 1970s-style stagflation — the inability of a recession to bring inflation back down again.

That outcome would require keeping interest rates high despite the recession this policy causes.

But for now, at least, central banks are punting that stagflation will not be the outcome. They’re waiting for the coming recession to solve their inflation problem.

The only question is how high interest rates will have to go before the recession hits and whether it’ll feature a financial crisis too.

It’ll be crucially important that you are not the weakest link — that you can weather higher interest rates than the rest of us. Because rates will divide our lucky country into those caught up in the recession and those who escape it.

Until next time,

Nick Hubble Signature

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend