Inflation is overwhelmingly the greatest current economic concern of most Australians, according to a recent community survey by the Reserve Bank of Australia (RBA).

Many Australians seem perplexed about what causes inflation and how it can be controlled. Most know that the Reserve Bank is responsible for trying to keep the inflation rate within the 2 to 3 per cent target range. They also know that the RBA controls the cash rate, which affects interest rates on loans and savings.

A surprising finding of the RBA survey was that over half of those polled thought higher interest rates would lead to higher inflation. In contrast, the RBA raises interest rates with the purpose of lowering inflation. These diametrically opposed views cannot both be correct. Who is right, the public or the RBA?

We need to know: What is the primary cause of inflation? And, what can be done to reduce it?

A primary cause of inflation was identified in 1965, when American economist and statistician Milton Friedman famously declared, ‘Inflation is always and everywhere a monetary phenomenon caused by excessive money supply growth.’

Born in San Francisco, in 1912, Friedman had a long and distinguished career in US universities and government agencies. His economic insights made such a huge impact on government policies throughout the world that he was awarded the 1976 Nobel Prize for Economic Sciences.

Friedman made his famous statement after he, and his colleague Anna Schwartz, analysed almost a century’s comprehensive US monetary data, from 1867 to 1960. They not only found a strong correlation between money growth and inflation, but they also established causation. Sudden jumps in money growth caused inflation spikes about two years later.

In a subsequent study of century-long UK data, with a different economy and central banking structure, they found remarkably similar results. Later studies of monetary data by other researchers across multiple countries and over long periods of time confirmed Friedman’s claim. Money supply growth was very strongly correlated with subsequent inflation, usually around two years later.

The implication was that controlling inflation should be achievable by controlling money supply growth. This raises the questions of what is money supply and how can its growth be controlled?

In simpler days of yore, money was just coinage – gold, silver, and bronze – or perhaps salt, rum or cowrie shells. We are still reminded of those simpler times at the Olympic and Commonwealth Games, when prized gold, silver and bronze medals are awarded to winning competitors. Money supply in days of old could be tallied as the total value of coins in circulation.

Now, in our modern and sometimes incomprehensible times, money supply is much more complicated. It comes in many different forms in addition to coins, including bank notes, credit cards, savings deposits, personal loans, and even cryptocurrency.

Boffins in ivory towers have coined marvellously creative names for money supply: M1, M2, and M3. With wild flair, economists have named these: narrow money (coins and paper money), near money (M1 plus savings), and broad money (M2 plus investments) respectively.

While these terms enable money supply to be measured (albeit in different ways) the question remains: how can money supply be controlled?

During the period 1976 to 1985, the RBA controlled Australia’s money supply in several ways. Some of its actions lacked transparency. RBA officials had private discussions with retail bank executives, pressuring them to restrict lending.

The main public method required each bank to transfer to the RBA a portion, the Statutory Reserve Deposit (SRD) ratio, of the funds deposited by customers with the bank. By increasing the required portion, the RBA could reduce the remaining money available for the bank to lend, thereby reducing the money supply.

However, this apparent solution to the problem of controlling inflation failed. As the RBA controlled the ability of the big banks to lend money, other money lending entities emerged: such as building societies, credit unions and foreign banks. They were not controlled by the RBA. The result: both money supply and inflation grew too fast.

The RBA, recognising the failure of the SRD to control inflation, abandoned its use in 1988 and reduced the ratio to zero. Along with the central banks of other comparable countries, the RBA spent some years seeking an effective alternative method of controlling inflation.

In January 1990, the RBA announced that the primary tool for seeking to control inflation would be the cash rate: the interest rate that banks pay to borrow funds from other banks in the money market overnight. This influences all other interest rates, including mortgage and deposit rates – across banks and other lending entities.

Announcing the cash rate publicly is more transparent and has been more effective in controlling inflation.

During the two decades before the change, over the 1970s and 1980s, annual CPI inflation averaged 9.0 per cent – well outside the CPI target range of 2 to 3 per cent. In contrast, during the following three decades, from 1990 to 2020, the average annual CPI inflation was 2.4 per cent – near the centre of the CPI target range. The RBA’s change from targeting money supply growth via the SRD, to targeting inflation via the cash rate, has proved very successful.

Modelling by the RBA suggests that a change in the cash rate has maximum impact on the inflation some one to two years later. It’s a bit like turning on a hot tap then waiting for ages for hot water to emerge. The tardy response of the inflation rate to cash rate changes is problematic for the RBA. The board cannot see the impact of a decision until many months later.

The common view that cash rate hikes are inflationary is understandable. The immediate effects include increased rents and home loan rates. Since these expenses dominate many family budgets, people are liable to feel financial pressure. To the average mortgage holder, saying that higher interest rates will cure inflation seems crazy.

However, when loans are costlier and savings are more profitable, loan applications fall and savings grow. The net effect is to reduce money supply and thereby reduce inflation. But these benefits emerge slowly, a year or two later.

The Reserve Bank’s task of seeking to keep inflation within the 2 to 3 per cent range is unenviable. But we need to remember, ‘Inflation makes the wealthiest people richer and the masses poorer,’ as writer James Cook has said.

The delay between raising the cash rate and seeing inflation cool creates a painful disconnect for everyday Australians, whose immediate reality is rising mortgage bills and rent. Yet history demonstrates that enduring short-term tightening is the only proven remedy to prevent long-term erosion of living standards.

As Milton Friedman famously observed, inflation acts as ‘taxation without legislation’. The RBA’s delayed remedy is a price worth paying to preserve Australia’s economic stability.

Dr David Phillips is a former research scientist and founder of FamilyVoice Australia