This is why the latest jump in inflation has led some economists to fear that if expectations become “unanchored”, inflation could take root at a much higher level.
This fear explains why many are eager to use higher interest rates to bring real inflation down as soon as possible. If the fall in real wages contributes to accelerating the process, so much the better.
Two small problems with this. For starters, there is little evidence – either here or in other wealthy economies – that expectations have risen. Apparently, everyone expects the inflation rate to become much lower again before long.
Our modern oligopolistic economy gives many large corporations a lot of power over the prices they can charge.
In the real world of corporate and worker price-setting, it takes much longer for expectations to change prices than for stock and other financial market prices to rebound.
But the underlying reason why worries about worsening expectations are misplaced is that since this theory became so influential in the 1970s, the mechanism by which the expected rate of inflation becomes the actual rate has broken down. .
Companies retain the ability to raise prices when they choose – and to lower those prices if they find they have pushed too far and lose sales – but organized workers have largely lost their ability to force employers to grant higher salary increases.
If you doubt that, ask yourself why the number of days lost to strikes is now the smallest fraction of what it was in the 70s. We’ve seen a small strike lately, but it comes almost entirely public sector workers – the bulk of the workforce that is still heavily unionised.
But the collapse of inflation expectations theory and the “wage-price spiral” as explanations for the relatively modern phenomenon of inflation – a Continue rise in the general level of prices – prompts us to look elsewhere for explanations.
Much of this is the message that economists who specialize in the study of competition must convey to financial economists such as Lowe: you don’t seem to realize that our modern oligopolistic economy gives many large corporations a great deal of pricing power. that they able to charge.
Oligopoly concerns the few large firms that dominate a particular market achieving a tacit agreement to keep prices high and stable and limit their competition for market share to areas other than price such as product differentiation and marketing.
As former competition czar Rod Sims has pointed out, this significantly reduces the ability of higher interest rates to influence prices in many broad slices of the economy.
But if many large companies can improve their profitability by deciding to raise their prices, why did they wait until just a year ago to decide to start hustling them? Because it’s not that simple.
All companies would like to increase their prices all the time. What stops them is that they know they cannot charge more than “what the market will bear”. They worry about two things: what will my competitors do? And what will my clients do?
When there is a big increase in input costs, knowing that all of my competitors are facing the same cost increase gives me confidence that we are all going to pass it on to the customer at the same time.
This is why it was the sudden, large and widespread increase in the cost of imported inputs caused by the pandemic and the war in Ukraine that triggered the latest surge in retail price increases.
But, as Lowe keeps saying, increases in supply chain costs don’t explain everything rising retail prices. He points out that companies find it easier to raise prices at a time when demand is high and people are spending. Its interest rate hikes are aimed at preventing demand from being so strong and conducive to higher prices.
But the less obvious point – especially for people fascinated by the neoclassical way of thinking – is the role of psychology. I have a great justification for raising my prices, but nobody matters. If my costs have increased by 5%, but I increase my prices by 6%, who should know?
Sims reminds us that this is how companies with pricing power behave. They increase their prices and profits in ways that are not easy for their customers to notice.
This covers large companies. Overall, small businesses don’t have much pricing power. But “what the market will bear” is greater when the media has spent months sweetening its customers with relentless talk of inflation and rising prices.
Lowe can’t say, but it’s not the uncooperative workers that are his problem, it’s the companies taking advantage of the opportunity to slip in a little more for themselves.
Ross Gittins is the economics editor.
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