

Lowe's secret inflation fear: big companies' price-setting power
February 23, 2023
Despite the grilling he got in two separate parliamentary hearings last week, Reserve Bank governor Dr Philip Lowes explanation of why he was preparing mortgage borrowers for yet further interest rate increases didnt quite add up. There seemed to be something he wasnt telling us and I think I know what it was.
We know that, as well as rising mortgage payments, we have falling real wages, falling house prices and a weak world economy. So its not hard to believe the Reserves forecasts that the economy will slow sharply this year and next, unemployment will rise (it already is), and underlying inflation will be back down to the top of the 2 per cent to 3 per cent target range by the end of next year.
So, why is Lowe still so anxious? Because, he says, its just so important that the present high rate of inflation doesnt become ingrained. If inflation does become ingrained in peoples expectations, bringing it back down again is very costly, he said on Friday.
Why is what people expect to happen to inflation so crucial? Because their expectations about inflation have a tendency to be self fulfilling.
When businesses expect prices to keep on increasing rapidly, they keep raising their own prices. And when workers and their unions expect further rapid price rises, they keep demanding and receiving big pay rises.
This notion that, once people start expecting the present jump in inflation to persist, it becomes ingrained and then cant be countered without a deep recession has been ingrained in the conventional wisdom of macroeconomists since the 1970s.
They call it the wage-price spiral thus implying its always those greedy unionists who threw the first punch that started the brawl.
In the 1970s and 1980s, there was a lot of truth to that characterisation. In those days, many unions did have the industrial muscle to force employers to agree to big pay rises if they didnt want their business seriously disrupted.
But thats obviously not an accurate depiction of whats happening now. The present inflationary episode has seen businesses large and small greatly increasing their prices to cover the jump in their input costs arising from pandemic-caused supply disruptions and the Ukraine war.
Although the rate of increase in wages is a couple of percentage points higher than it was, this has fallen far short of the 5 or 6 percentage-point further rise in consumer prices.
So Lowe has reversed the name of the problem to a prices-wages spiral. In announcing this months rate rise, he said that given the importance of avoiding a priceswages spiral, the board will continue to play close attention to both the evolution of labour costs and the price-setting behaviour of firms in the period ahead.
Lowe admits that inflation expectations, the thing that could set off a prices-wages spiral, have not risen. Medium-term inflation expectations remain well anchored, but adds it is important that this remains the case.
If thats his big worry, Treasury secretary Dr Steven Kennedy doesnt share it. Last week he said bluntly that the risk of a price and wage spiral remains low, with medium-term inflation expectations well anchored to the inflation target.
Although measures of spare capacity in the labour market show that the market remains tight, the forecast pick-up in wages growth to around 4 per cent is consistent with the inflation target.
So, why does Lowe remain so concerned about inflation expectations leading to a priceswages spiral that he expects hell have to keep raising the official interest rate?
There must be something hes not telling us. I think his puzzling preoccupation with inflation expectations is a cover for his real worry: oligopolistic pricing power.
Why doesnt he want to talk about it? Well, one reason could be that the previous government has given him a board stacked with business people.
A better explanation is that hes reluctant to admit a cause of inflation thats not simply a matter of ensuring the demand for goods and services isnt growing faster than their supply.
Decades of big firms taking over smaller firms and finding ways to discourage new firms from entering the industry has left many of our markets for particular products dominated by two, three or four huge companies oligopoly.
The simple economic model lodged in the heads of central bankers assumes that no firm in the industry is big enough to influence the market price. But the whole point of oligopoly is for firms to become big enough to influence the prices they can charge.
When there are just a few big firms, it isnt hard for them reach a tacit agreement to put their prices up at the same time and by a similar amount. They compete for market share, but they avoid competing on price.
To some degree, they can increase their prices even when demand isnt strong, or keep their prices high even when demand is very weak.
I suspect whats worrying Lowe is his fear that our big firms will be able keep raising their prices even though his higher interest rates have greatly weakened demand. If so, his only way to get inflation back to the target band will be to keep raising rates until he crunches the economy and forces even the big boys to pull their horns in.
Its hard to know how much of the surge in prices we saw last year was firms using their need to pass on to customers the rise in their input costs as cover for fattening their profit margins.
We do know that Treasury has found evidence of rising profit margins mark-ups, as economists say in Australia in recent decades. And a study by the Federal Reserve Bank of Kansas City has found that mark-ups in the US grew by 3.4 per cent in 2021.
But for Lowe (and his predecessors, and peers in other central banks) to spell all that out is to admit theres an important dimension of inflation thats beyond the direct control of the central banks.
If he did that, he could be asked what hes been doing about the inflation caused by inadequate competition. Hed say competition policy was the responsibility of the Australian Competition and Consumer Commission, not the Reserve. True, but what an admission.
In truth, the only person campaigning on the need to tighten competition policy in the interests of lower inflation is the former ACCC chair, Professor Rod Sims. Has he had a shred of public support from Lowe or Kennedy? No.
Final point: whats the most glaring case of oligopolistic pricing power in the country? The four big banks. Since the Reserve began raising interest rates, their already fat profits have soared.
Why? Because theyve lost little time in passing the increases on to their borrowing customers, but been much slower to pass the increase through to their depositors. Has Lowe been taking them to task? No, far from it.
But his predecessors did the same as no doubt will his successors, unless we stop leaving inflation solely to a central bank whose only tool is to fiddle with interest rates.
First published in the Sydney Morning Herald, Monday, 20 February 2023

Ross Gittins
Ross Gittins is the Economics Editor of The Sydney Morning Herald.