Daily Archives: 06/06/2011

Supply Side Inflation

There are three types of inflation.  The most common is demand-pull.  The other two are cost-push.

Professor John T. Harvey likes to label these as cost-push/Act of God & cost-push/market power.  Another name for these is supply side [shock] inflation.

Cost-push Inflation in both cases is when a product that is an input to another product increases in price due to its apparent scarcity.

A recent example in Australia would be the price of bananas due to Tropical Cyclone Yasi destroying the entire Queensland crop.  The price of bananas are currently beginning to return to normal but I saw bananas as high as $18 kg.  More recently I saw them at  $15kg.  This is an example of Cost-Push/Act of God Supply Side Inflation.

If environmental factors continue to be an issue in food production, this type of inflation will become commonplace rather than an event that seldom occurs.  Whilst environmental devastation is not exactly uncommon, it is not exactly commonplace either.  Most central banks attempt to ignore any cost-push inflation due to any acts of God as they are aware this creates price volatility and will usually pass as a temporary inflation.  You can see this in the banana example as the price continues to fall as production returns to normal and the price begins to stabilise.

The other type of supply side inflation, cost-push/market power can be devastating.  It usually consists what is known as a swing producer – a swing producer is a supplier or a close oligopoly of suppliers of any commodity, controlling its global deposits and possessing large spare manufacturing capacity – which have considerably influence on the world price of that commodity and is effectively the price setter of that commodity.

The two most common swing producers, that is price setters known in the world are De Beers for their control of diamonds and OPEC for its control of oil as demonstrated in the Oil Crisis of the 70s/Yom Kippur war.  The biggest producer of oil in OPEC is Saudi Arabia which makes them the price setter.

This lead to ever increasing inflation due to the price of oil, a supply side shock, which the governments of the day treated as demand-pull inflation, so tried to deal it with tightening the labour market which lead to ever increasing unemployment.  This is a stagnant economy with high inflation which has subsequently been named stagflation.

Bill Mitchell says:

The stagflation occurred because first there was a huge external supply shock (oil price rise) to oil dependent economies. There was no shortage of oil – just a well organised cartel (OPEC) which could set the price at the level it desired. The reaction by Government was to contract demand while the reaction of organised labour and employers was to enter a slug-fest to determine which side of the workplace would sacrifice to make “real room” for the external cost shock. The latter generated a wage-price spiral while the former generated the first sharp rises in unemployment in years.

Most inflation pressures in the economy at present are driven by supply-side causes. The last thing you want to do is invoke demand deflation policies to address a supply-side originating cost squeeze. That policy approach just results in stagflation.  Or in English, create unemployment so people can’t afford anything and thus lowering demand and thus accelerating a decrease in prices.

The solution to any type of inflation is find alternatives to supply, which the US did during the era of stagflation by opening up their natural gas pipelines and Australia did likewise with the Moomba to Sydney pipeline and the eventual floating of the dollar along with other deregulations.

Speaking of Oil, Prince Alwaleed bin Talal of Saudi Arabia said an oil price of $70 to $80 a barrel is likely and has said it twice recently.  This means a drop in the price of related goods and petrol in the near future.

Supplemental Reading: Stagflation

Update 24/6/11: Seems the Saudis are now aiming for $80 to $90