The latest piece for AFR went up yesterday. It is behind a firewall, so here for readers is a version of the draft I sent. Essentially it is making the point that inflation has not arrived thanks to Zero Interest Rate Policy (ZIRP), but rather due to Zero Covid and Zero Carbon policies and that, for all its irrationality, reversing ZIRP would not only not solve inflation, but likely cause stagflation.

There is an old (and powerful) image of policy error; that of dragging a brick across a rough surface attached to a piece of elastic. For a long time, nothing seems to happen, then suddenly it comes loose and hits you in the face. Central Banks everywhere seem to be at that point, after years of ultra-loose monetary policy designed to stimulate inflation, it finally seems to have arrived. And they don’t know what to do about it. The problem is that the policy error isn’t limited to (or even really down to) interest rates, inflation hasn’t arrived because of their loose monetary policy and many, rightly, fear that if they now switch to tighter policy that they will end up with the worst of all worlds, which is Stagflation.

We have talked before about the Deadly Trinity of Zeroes, Zero Interest Rates, Zero Covid and Zero Carbon. For years, Zero Interest Rates Policy, or ZIRP, failed to stimulate the consumer price inflation that the models claimed it would – although it generated plenty of asset price inflation – but a combination of Zero Covid fracturing global supply chains and the ratchet effect of multiple rounds of Zero Carbon policies on both energy costs and energy supplies have now done it for them. It is they who have both stretched the elastic and loosened the brick. The risk now is that, while we remain stuck with the Zero Covid and Zero Carbon crowd, the ZIRP disciples give way to the reborn bond vigilantes who would collapse demand whilst being as unable to influence inflation on the downside as their predecessors were on the upside.

We have long argued that, in countries with large amounts of floating rate debt, such as Australia and the UK, the impact of monetary policy is in practical terms the same as a fiscal policy, effectively changes disposable income after tax and mortgage payments. It is also balance sheet dependent. Cutting rates in the early 2000s when there was scope and appetite to expand balance sheets led to housing booms, while raising them caused busts. Post GFC, flat or deleveraging balance sheets were a key reason why monetary policy appeared to be ‘pushing on a string’. For the same reason of over- extended balance sheets, raising rates now to ‘counter inflation’, as the bond economists are demanding, risks crushing the small amount of disposable income available for anything other than essential goods and services.

The real problem is that the inflation we are now  seeing is not in discretionary items, but in essential goods and services. This is a supply issue rather than a demand one and the idea that the solution is to raise the cost of mortgages and thus collapse discretionary consumer demand makes no sense to anyone outside of an econometric modeller working in a Central Bank. It won’t change demand for the essential goods and services, they are, after all, essential, but it will affect everything else. Disposable income is already being squeezed by the other zeros –  higher taxes to pay for Covid, as well as higher energy costs driven by a toxic combination of terrible long-term planning and aggressive short-term green pricing policies.

The supply problems are also a function of the other Zeroes. Covid restrictions have revealed the fragility of the global just-in-time supply chain, creating logistics problems everywhere and for almost everything. This will be slower to unwind than we first thought and we have what we might think of as a form of Economic Long Covid (ELC.) Meanwhile, the political imperative that has taken over Climate activism is also having impacts on supply. Raising the cost of energy, or limiting its usage for Zero Carbon reasons, will, by definition both increase the cost and reduce the supply of ‘stuff’.

This all comes back to the concept of ‘The China Price’, essentially that because of its huge scale, whatever China wants to buy goes up in price and whatever China makes and is trying to sell goes down in price. Historically Australia has been keenly aware of this on the demand side, Chinese demand for raw materials post the GFC caused a boom that was subsequently matched by a boom in invisible imports such as housing, education and real estate. Europe and the US meanwhile tended to see the other side of the equation as Chinese supplies of cheaper manufactured goods dominated global supply chains, which was great for consumers even if it was less welcome from a jobs perspective. China obviously knows this, particularly on the purchasing side, which is why periodically it seeks to choke off speculative buying of commodities like iron ore and coking coal, even copper, but it is not clear how much the econometric models have properly accounted for the disinflationary side of China ensuring that there are more than enough goods, or the impact that their disappearance will have. The temporary reductions in Chinese output in response to power shortages have given an early insight into how this may turn out.

On balance we see a step up in price levels rather than an inflation spiral, just as Japan saw a step down 30 years ago, leaving markets to find a new equilibrium. In the meantime, there is an overdue recognition that the Zero policies do not have Zero Costs attached.