How Interest rates really influence inflation

How do interest rate rises bring down inflation. This is something we never think about since superficially it is obvious: people and businesses have less money to spend, so they buy less, putting downward pressure on prices, and then less stuff is made so unemployment rises which further reduces demand and also puts downward pressure on wages. But is that how it really works?

In most of the Western world central banks have been using interest rates to influence inflation. Also there is a surge in house prices and rental rates. This has led to a lot of discussion in Australia, and probably everywhere, about the "housing crisis". In the course of this we've had two contradictory points.

• Looking at history, there is a good correlation of higher unemployment with lower house prices and rental rates. And housing costs are a big part of the basket of goods that determine the inflation rate.
• Yet housing supply is very inelastic. Going from increased demand to higher prices to the building of more houses takes years.

The real link is that there is no shortage of accomodation. If you lose your job then, force majeure, you can't pay the rent or the mortgage. You move back in with your parents or to your brother's garage, or something like that. Quite quickly the supply of rental properties and houses for sale can rise. On the other hand suppose employment is rising, as it did rapidly after the pandemic. Often when people get a job they will want to move, to be closer to the new job, or to widen their romantic opportunities, or just to have more freedom or comfort. Then we saw housing prices rise despite the rising interest rate, and rental rates soar as availability plummeted.

So it turns out that accommodation is quite elastic. Which is lucky because that is the service that is most directly affected by interest rates. If the central bank can get unemployment back where it wants it then the housing crisis will fade away.

However this is a totally unsatisfactory situation. We have one arm of government, Centrelink in Australia, making the life of the unemployed hell, trying to force them to find work, while another arm of government is trying to make sure that work is not available.

I won't make my normal mistake of coming up with a glib solution off the top of my head. But I will say this: When circumstances, such as a pandemic or a drought, have the effect that total production of goods and services is forced to fall, then the government needs to start the uncomfortable conversation of how the burden of reduced income and consumption is to be equitably shared. The current system of slamming the people at the bottom who struggle to keep a job is morally unacceptable.

Climate Change and Energy Policy

Like governments of Left and Right before, the current ALP government in Australia has expressed the obvious fact that we can't move from fossil fuels to wind plus solar plus storage in the necessary time frame. The talk of carbon capture is a fantasy. One reason is that we need baseload power giving "inertia" to the grid, and we need high temperatures for many industrial applications. Nuclear energy covers those bases.

Another reason for nuclear energy is that we are guaranteed to overshoot on carbon emissions, and we are going to need huge amounts of energy to unwind that. Advanced (but not small) nuclear energy is the only plausible route. If fusion doesn't happen then thorium reactors can burn the waste we've got and make fuel continuously from cheap ingredients.

And what good does it do for Australia to go net-zero on wind and solar if most of the world doesn't have that option? It's not as if Australia's actions can protect Australia's climate. We need the world to change,  so we need to make nuclear energy work for the whole world, both for daily energy and even more for the extra energy we need to undo our inevitable overshoot. As a rich technologically advanced country we need to pitch in.

Until a few years ago nobody worried about climate change, except when there was a drought. However commentators and the public are starting to realise that climate change is more about floods than droughts. The fact that air can hold 7% more water for every degree of warming is getting increasing mentions. Of course this is a double edged sword, since it means that if the air is dry, perhaps on the lee side of mountains, then it can suck more moisture out of the ground it passes over. But more often it means that there is more water to fall, and even if it doesn't rain, many plants can get by sucking moisture out of the air. Given that droughts can be worse when they happen, we need to put more engineering effort into buffering the water when it occurs. Understanding aquifers and how to recharge them is a better option than building dams.

Young people are very worried by the lies being spread about the dangers of climate change. Rising sea levels, and many other things, are going to be bad, and we need to fix the problem carefully and energetically, but not rashly. Nobody needs to die. Indeed rash remedies are more likely to kill people than climate change itself.

But then we come to the current crisis, which is the drift towards war. Wars are fought with fossil fuels, and the good guys need to be ahead of that game. More significantly Russia is financing its war with fossil fuel exports. I endorse Doomberg's view (https://newsletter.doomberg.com/p/broken-record-81d): The way to fix that is to ensure that there is a plentiful supply, driving the price down. The effort to slow Russia's exports has created a shortage that is harming economies on our side while increasing Russia's income. Ukraine's attacks on Russia's infrastructure might slow Russia's income, but that will exacerbate the shortages. We need to utilise the resources we've got and fix the climate and other problems later.