Inflation's mechanics - and the importance of improving productivity

It seems hard to believe that just two years ago some business commentators were suggesting that the inflationary problem was behind us. The world was on a sustained low inflation growth trajectory. Now we have the return of inflation in combination with slow growth, something we have not really seen the 1970s.

Inflation's mechanics rest on supply and demand. The policy response is far more complex.

Prices rise as demand rises. This draws out more supply, but with a lag. In the first instance, business uses spare capacity to meet increased demand. Beyond this point, new investment is required to build greater capacity. This adds to demand and to prices.

As capacity increases, so does production. This places downward pressure on prices. Sustained inflation occurs when increasing demand stays in front of increasing production capacity.

The only way to stop this is to reduce demand. However, this is where things get complicated.

Monetary policy, increased interest rates, is the usual weapon adopted by central banks. As interest rates rise, funding whether for consumption or investment drops. This leads to reduced demand, placing downward pressure on prices.

So far so good. However, the story does not stop here. This is where things get complicated.

In a global world, the capacity of individual countries to control prices is affected by events elsewhere. With global inflation, import prices rise. These rises may be offset to some degree if, as happened in the Australian case, rises in interest rates help strengthen the currency. This helps consumers, but can further reduces demand because of its impact on exports and domestic production.

The economy slows. Now things get really complicated because inflationary pressures do not end at once. Central banks now face a delicate balancing act: reduce interest rates to help increase demand or hold to keep pressure on inflation.

In the past, fiscal policy was used to help control upturns and downturns. Governments are now reluctant to do this, placing greater weight on monetary policy.

Falling interest rates increase personal and business cash flows, supporting greater consumption and investment. However, they can also lead to falls in the exchange rate. To some degree this adds to domestic demand, but it also increases local price pressures. Further price pressure may emerge as local demand begins to increase again.

To my mind, the big conundrum in all this is just how to ensure that prices stay down as growth resumes. To my mind, the answer has to lie in keeping productivity growth faster than the rise in input costs, including wages.

The old comparative statics model suggested that in the first stages of the upturn the existence of spare capacity meant that productivity would automatically rise faster than input costs. However, this effect comes to an end as that spare capacity is soaked up. Price pressures then re-emerge, leading to another downturn.

One distinctive feature of the last growth wave was its sheer length. This was supported by a long period of above average productivity growth. If this is correct, then a key issue becomes what might lead to another such productivity wave.

I am far from certain that I have an answer here at either national or international levels.