Why do we target 2% inflation? Why do prices always rise? Isn't the aim of investment to make things cheaper? I've thought for a long time the standard explanation of inflation was crap, but never read a convincing alternative. But since research into price rises during covid made clear a new driver of inflation - higher profit margins - debate on inflation has sharpened up. Here's the story so far...

First, recall the standard line on inflation provided by sell-out mainstream economists for public consumption: "High inflation is painful. Even if wages keep pace with price growth, thereby preserving workers' incomes in real terms, it undermines the function of money in the economy. Long-term investment and saving decisions become more of a gamble. Yet deflation carries its own costs, too. Worryingly for mortgage-holders and Governments alike, it raises the value of debts in real terms, which can generate a self-sustaining depression as incomes keep falling relative to debt payments. That explains why central banks aim for a low but positive rate of inflation" (Economist, 23/07/22).

That explanation leaves a lot unexplained. Why not 0% instead of 2%? Why do reserve banks decide interest rate targets? Why do we privilege interest-targeting ("monetary policy") over targeted Government spending ("fiscal policy") today? Can alternatives like price controls be more appropriate? And most important - who wins and who loses when interest rates are raised and lowered? Every year, workers lose when the spending power of their wages decreases. Who needs inflation? That's the question!

The Emergence Of Profit-Driven Inflation

If you ask Google what caused the recent burst of inflation, you will likely get back the neoliberal bullshit - prices increase when demand for goods and services is higher than supply, and when there is too much money (because those bloated Governments have borrowed). Ask your question a little more carefully, like "what contributed to higher inflation after covid", and you will get one part of the full answer. There were sharp increases due to supply chain disruptions and increased energy costs. This was the explanation we all heard at the time.

But as usual you need to know the right person and the right question to get reliable and comprehensive answers on the Internet. Australian/UK contrarian economist Steve Keen is a good place to start. He provides an excellent presentation titled "Why The Fed Fails At Inflation" showing that company markups (and hence excessive profit taking) were the main culprit after those covid disruptions started the inflationary cycle.

By contrast, wage increases were below inflation, which means that the US Federal Reserve's lifting of interest rates to reduce wage pressures was both unnecessary and harmful. Here's that link if you'd like to watch Steve Keen's presentation "Why The Fed Fails At Inflation", which provides evidence for some of the key points made above.

In that presentation, Keen also takes an illuminating look at the long history of inflation. The long-run average is around 3%, but there were also very high markups causing inflation in the First World War, when US firms took advantage of unregulated markets and heavy Government borrowing to expand weapons production. Aware of this, the US set up a prices commission in World War 2 which successfully held price rises to lower levels, despite much greater borrowing.

Female Economist Shows Up The Men

That wartime lesson turns out to be just as relevant today. Back when covid started, economist Isabella Weber identified higher markups and profits as the main cause of price rises in the paper "Sellers' Inflation, Profits And Conflict: Why Can Large Firms Hike Prices In An Emergency?" When she suggested US price controls instead of raised interest rates, neoliberal Paul Krugman publicly called her "truly stupid". Her new approach to research may not have won the social media war, but that's just the shout of vested interests.

Instead of using unrealistic economic models, Weber used artificial intelligence (AI) and natural language programming to comb through hundreds of thousands of real-world companies' earning calls that took place during the pandemic to see how company executives were talking about prices with their shareholders. She found companies talked positively about price influxes, reasoning that since everyone was going to increase prices, they could increase prices far enough to boost profits. "If there's an economy-wide shock ... companies actually express relatively positive sentiment about these cost shocks, because these cost shocks send a clear signal to everybody in this market that this is a window of opportunity, this is a moment to hike prices," Weber said:

• "pricing will be an important lever for us this year and is expected to drive most of our growth"
  Chief Executive Officer (CEO) of Hershey
• "Most of our - if not all - of our net sales growth for 2022 would be driven by price/mix"
  Chief Financial Officer (CFO) KelloggCo

While traditional economic models claim that market forces would prevent this from happening - a firm will lose its market share if it increases prices too high in relation to competitors - Weber argues that much of America's economy does not operate within traditional market forces. Competition in many industries has been whittled down by consolidation, giving more power to the big companies that dominate an industry.

The power of these sellers only goes up when there are economy-wide shocks, and they increase prices to pump up profit in return. This point was also confirmed in US research by Joseph Stiglitz and Ira Regmi ("The Causes Of And Responses To Today's Inflation", 2023), who found price rises were highest in the sectors with greatest market domination.

On Price Controls

Weber: "It's more effective to keep the genie in the bottle. Once it's out, it's harder to fight." Why did your proposal cause so much backlash? "The idea of price controls challenges the sanctity of market mechanisms". Back in her home country Germany, Weber worked the Government to implement some of the first strategic price controls on gas and heating prices after the Russian invasion of Ukraine and the loss of cheap Russian oil. The European Union followed.

Weber also had this to say: "I think we are in a historic moment where the far Right is as strong as it has been since the 30s and 40s, and I think this is extremely dangerous", she said. "It's not enough to walk around and say: 'I am defending democracy, therefore please vote for me'. To defend democracy, you have to deliver policies that the majority of people feel are actually making their lives better. Otherwise, it will be very, very hard to prevent the sliding down on the slippery slope towards a more fascist-looking political arrangement".

And the last word to Weber, from her paper "Big Oil's Profits And Inflation: Winners And Losers": "We have witnessed a profit and price explosion in the fossil fuel industry that started in 2021 and has increased in the wake of the war in Ukraine. Excess profits have unleashed a redistribution of incomes. This raises the question of who is reaping the benefits and who is paying the bill".

Local Greedflation, Yes Or No?

In Australia, research by the Australia Institute and the Organisation for Economic Cooperation and Development (OECD) both found that excessive corporate profits were largely responsible for driving the lion's share of the burst of inflation that followed covid lockdowns. The Australia Institute commented pointedly that "absurdly, many commentators have been blaming workers for the rise in inflation".

"Precious few people, certainly no one at the Reserve Bank of Australia, would admit that excessive corporate profits might have something to do with the cost-of-living crisis". In New Zealand, a report commissioned by Business NZ and released in May 2023 "found no evidence of widespread increases in profit margins driving up inflation in New. Zealand. It is an imported narrative not supported by the evidence". This report was widely repeated, including by the New Zealand Herald and Radio NZ.

But in August 2023, research by First Union researcher Ed Miller looked at food, housing and transport, which make up about three quarters of the pressure on the consumer price index. He found that at the beginning of the pandemic, 2020 to mid-2021, the labour contribution outweighed profits, but inflation was still low. But during the main period of rising costs, from mid-2021 to the end of 2022, the profit contribution accounted for 55% of pressure on the gross domestic product (GDP) deflator, while wages were less than a third at 28%.

Also, in the pre-pandemic period - mid-2016 up to the end of 2019 - "the profit contribution was very dominant: 64% of pressure on the GDP deflator comes from profits and less than 20% comes from labour". Recent US analysis by the Economic Policy Institute (5/9/24) showed that in the US the contribution of higher profits to inflation had reduced from earlier peaks by 2024 but was still over 30%.

Neoliberal Nonsense, Deflated

Milton Friedman* promoted the belief that Government borrowing created too much money, leading to inflation. He couldn't prove it, but famously claimed in 1959: "There is much evidence that monetary changes have their effect only after a considerable lag and over a long period and that the lag is rather variable", implying it's true but hard to measure. Later economists have shown that Government borrowing creates inflation only when the extra spending is badly targeted. *Milton Friedman, 1912-2006, the US economist who was the father of neo-liberalism. Ed.

Neoliberals are not inclined to let go of a good anti-Government line though, so when covid disrupted supply chains and corporations seized the opportunity to profit, they plugged their failed old slogan "it's overstimulation by Government, we must raise interest rates to slow the economy". This is just bad economics. The wrong problem was diagnosed, the wrong solution applied.

You can see how wrong it is here in NZ, where we got a head start on the US in implementing neoliberal economics because our conservative Coalition came to power 14 months before Trump. We've taken the neoliberal prescription and the economy has slowed so much we had the developed world's biggest recession in 2024.

Wages rose less than inflation during covid, but our new Government knew its preferred solution. Slow the economy, bring down wages, cut Government spending and services, privatise. Success, in neoliberal terms. Failure, in real life. Unemployment rose from 4.1% in September 2023 to 5.1% in December 2024, but that's the point. Unemployment drives down labour militancy and wages, while powerlessness increases disenfranchisement and boosts support for Rightwing solutions (see my book review of Mattei's "The Capital Order" elsewhere in this issue).

But here's the scary thing - the original neoliberal prescription in the 1920s was to reserve the costly tool of slowing the whole economy for those times when labour is a resurgent force and needs suppression. Are Act just ideological zealots, like (short-lived Prime Minister) Liz Truss in the UK before them, who get elected and can't wait to stomp on labour, whatever the cost to the economy? Or is this the new normal for the Right?

And The Magical Mystical 2% Inflation Target Came From NZ's Own Roger Douglas!

Back in 1988 we had a Labour government (sort of), recovering from inflation which had peaked at 15% the previous year. Finance Minister Roger Douglas went on TV to talk about his new monetary policy targeting inflation, an approach which hadn't yet been implemented anywhere. With inflation now at 10% he was asked if he was satisfied. In an off-the-cuff response he answered no, he'd really want inflation between 0 and 1%.

Incoming head of our Reserve Bank Don Brash got the follow-up job of working out a defensible target. Literature reviews suggested a target inflation rate might in reality be 1% below the nominal target. "It wasn't ruthlessly scientific" but they settled on 2%. "I spent an endless time travelling the country," Brash said. "I talked to farmers, to Rotary groups, to anyone who would listen, saying: 'This is going to be the target, so adjust your plans to that, or the social and economic costs will be considerable'".

2% gradually became a global norm but the US held off explicit public targets, while using 2% internally. An examination of its Open Market Committee transcripts up to 2013 showed officials overwhelmingly favoured 1.5% at first, but shifted to 2% after the huge 2008 recession, which gave the central bank more room to use interest rate cuts to stimulate the economy in slowdowns.

US Conservatives Demanded 0%, Fed Said No, Profits Would Suffer

Back in 1996, Republican leaders in the US Senate proposed a new target for the Fed, promoting "price stability" (0% inflation) after several studies suggested efficiency savings with low transitional costs. The Fed looked more closely and pointed out that when productivity growth is low, as it has been in the US since the 1970s, firms rely heavily on inflation to reduce real wages. The "cost" of 0% inflation would be large in terms of lost profits.

Their research noted: "Workers' resistance to nominal wage cuts is tied to their fundamental feelings about fairness and their suspicions of employer motives. The experience of the Great Depression is instructive. After considerable deflation in the early 1930s, resistance to nominal wage cuts apparently stiffened in the mid-to late 1930s. Legal and institutional changes supporting wage rigidity were put in place". Full story "Low Inflation or No Inflation: Should the Federal Reserve Pursue Complete Price Stability?". In short, steady inflation of 2% reduces real wages without action from businesses, increasing profits. Workers start on the back foot, trying to regain that loss in negotiations.

Distributional Effects Of Inflation

Examples where inflation leads to transfer of income and wealth:

• Companies win: profits rise because real cost of wages falls 2% automatically every year
• Workers lose: the real buying power of wages is reduced
• Governments reduce expenditure: Secondary social welfare payments are never adjusted for inflation by conservative Governments
• Beneficiaries and pensioners lose: the value of rent supplements and other payments reduce
• Debtor vs creditor: debtor e.g. homeowner with mortgage wins as inflation deflates debt cost

Examples where relying on high interest rates to reduce inflation create transfers:

• Lower income households face higher inflation rates, with less capacity to cope
• Companies with market power raise prices and profits without restraint, costing consumers
• Renters lose big when interest rates go up because landlords pass costs through to rents

Examples where low interest rates to manage economic crises create transfers:

• Asset prices are inflated, providing a massive free wealth transfer to the already rich, paid for by future citizens who pay higher prices for essential services like water, housing, road tolls etc
• Cheap debt is extended to companies who use it to inflate share prices, lifting consumer prices

Sectors which benefit from inflation:

• Housing speculators profit from tax incentives for housing inflation, renters lose
• Companies with market power use rising costs as a pretext to increase prices and profits
• Fossil fuel companies with low costs of production, and their high wealth shareholders
• Fossil fuel profit explosions undermine macroeconomic stability by flow on increases
• Poor households and nations are the main victims of these climate change deniers

How Much Did The Rich Benefit?

The best research I read was Ferguson and Storm's chart-filled 45-page 2024 working paper for the Institute for New Economic Thinking. The authors' conclusions are blunt:

• Central bankers' claims that keeping inflationary expectations anchored played a key role are disproved by their own surveys, showing low-income Americans did not believe their assurances
• A major factor in the decline of inflation is the simple fact that America's workers were unable to raise wages in line with the cost of living
• The recovery of economic growth must be attributed to the unprecedented increases in asset prices, which persisted despite monetary tightening by the Federal Reserve and which boosted consumption of the rich through the wealth effect

They point out that affluent Americans financed this spending spree out of increases in wealth "which had no peacetime historical precedent". Total household wealth rose by $US37 trillion during these four years, as American society and the US economy were going through a pandemic, a recession and an uncertain recovery process that included a significant rise in the inflation rate.

In fact, during 2020-2023, aggregate US household wealth rose 45% above its longer-run trend. The distribution of the aggregate wealth gain is heavily biased in favour of the rich. The wealthiest 1% of households captured 30% of this spectacular rise in financial wealth; the wealthiest 10% seized 59% of the wealth gains (amounting to $US21.7 trillion). The bottom 50% of the wealth distribution, in contrast, received a pitiful 5% of the aggregate increase in household wealth (or $US1.8 trillion).

"Rising wealth inequality and the uneven wealth effect have hidden the reality of America's dual economy from view... Most of the population actually has experienced a hard landing. By contrast, the rich and super-rich have many reasons to celebrate a very soft landing indeed". And looking ahead, they point out that service sector inflation continues. "Strong demand for services from the affluent and especially the super-rich is propelling many price rises in that sector. Over time this historic transfer is also sucking more and more resources into the affluent top sector of America's dual economy. The flow of workers into high end restaurants as day care, nursing homes, and other lower wage industries struggle, offers an especially vivid example".

Class Conflict And Inflation

French economist Olivier Blanchard emphasised the class struggle behind inflation dynamics: "A point which is often lost in discussions is that inflation is fundamentally the outcome of the distributional conflict, between firms, workers, and taxpayers. It stops only when the various players are forced to accept the outcome". He went on to explain that at some times in history, workers were in a strong position to bargain for higher wages given rising prices. More recently, firms with market domination are in a stronger position to increase prices.

Or the State may play an active role through fiscal policy, slowing the economy; or subsidising the cost of energy to support the real wage and upwards pressure on nominal wages; those subsidies could be financed by increasing taxes through exceptional profit taxes, or through deficits and eventual taxes on future taxpayers. Here, Blanchard is highlighting the role of power: pricing power, bargaining power, Government power. Instead of talking economics, with all its unrealistic assumptions, we are talking political economy.

But under today's policy orthodoxy, the central bank is typically tasked with stabilising inflation. By slowing down the economy, it can force firms to accept lower prices given wages, and workers to accept lower wages given prices. The cost is paid by those on low wages and those who lost their insecure jobs. He says we can and should dream of a negotiation between workers, firms, and the State, in which the outcome is achieved without triggering inflation and requiring a painful slowdown.

Conclusions

Looking critically at past inflation management is important because, like pandemics, we can expect inflation to return. A range of new policies have been proposed to tackle future inflation more effectively and equitably:

• Assess the drivers behind any new bout of inflation and respond appropriately
• Look at the evidence before blaming inflation on wage rises
• Apply short term measures to meet short term pressures, which may include price controls, excess profit taxes etc
• Choose responses which minimise upward income redistribution to maintain living standards and demand for goods and services
• Increase targeted fiscal interventions; reduce monetary contraction and stimulation, a blunt tool with large distributional consequences
• Return interest rate setting to political control; “independent reserve banks” just means the decisions favour capital and are paid for by labour
• Exclude financial speculation in commodities markets
• Pre-emptively tackle the growing market power and monopoly which is generating inflation through excess profits

But in addition to past drivers of inflation, increasing geopolitical instability and looming climate crises are expected to add dramatic new inflationary pressures. So, my conclusion is we need to argue for a mix of economic policies targeting 0% inflation, so that wages are not automatically reduced. Without structural changes which shift power from capital to labour, we will not be able to halt global warming.

Watchdog - 168 April 2025