Readers, particularly those of Marketwatch’s vintage, will be familiar with stories involving that staple of the British fetes and fairgrounds, the Punch and Judy show.  As children’s’ entertainment goes, this is a pretty violent demonstration of the type of show put on in the 17th century.  Mr Punch generally beats all and sundry with his stick until they are subjugated but Mr Punch must then meet and defeat his nemesis, usually in the form of the devil.

What the heck is Marketwatch raving on about, you may, and probably should, ask?

Well, he was reminded of this example watching the manoeuvring of central banks as they attempt to combat inflation with their interest rate policies.  Some time ago we looked at what the banks can do, called monetary policy, and what governments can do, called fiscal policy.  Monetary policy pretty much comes down to setting interest rates, while fiscal policy covers such things as taxation, subsidies and the like.

You would have to be blind, deaf and mute not to know that the world has a problem with inflation.  Central banks are fighting it with just about the only tool they have, interest rates.

To digress, the irony of this is not lost on Marketwatch.  Although politicians love to blame the war in the Ukraine for all the economic woes which abound, this is a fraction of the truth.  The seeds of inflation were laid by the infusion of massive stimuli into the market by governments, with the tacit consent and co-operation of central banks.  They all thought it would be different this time.  But it wasn’t, and the very same banks which helped cause the problem, are now trying to solve it.

The trouble is, interest rate policy is like Mr Punch’s stick.  It is a blunt instrument, useful for bludgeoning something into submission, but indiscriminate in its effects.

So do rising interest rates solve the inflation problem?  Most definitely yes, if the central bank has the fortitude to see the job through.  I say that because we need to look at how interest rates actually manage the problem.

Firstly let’s look at house mortgages.  According to the 2021 census there are 9.8 million homes in Australia.  31% are owned outright and 35% are owned with a mortgage.  30% are rented and the vast majority rent from a private landlord.

When interest rates move, so does the cost of the mortgage.  Landlords have the option to adjust rents to compensate or increase their tax relief through negative gearing.  So the additional mortgage costs fall on the 35% of homeowners who have to adjust their spending elsewhere to keep paying a more expensive loan.

Whether we like it or not, this impact, painful as it is for households involved, is not enough to resolve rising inflation.

Well over half of our economy relies on consumer expenditure to sustain it and achieve growth.  A critical element in the inflation battle is, therefore, getting the consumer to spend less. But, as we have just noted, only a proportion of consumers will probably spend less and the rest appear to be untouched.

Well not quite.  Cost increases seen in the energy sectors and fuel costs affect everyone so, even without interest rate increases, consumer expenditure starts to slow as fuel and energy are regarded as essential costs.  Consumer confidence is important because if we uncertain about the future, we tend to hold off on some forms of expenditure.  Consumer sentiment at the moment is low, but there is not yet the evidence that savings are increasing as a result.

But that is still not enough.  The dilemma we face, in common with other countries such as the US, is that unemployment is really very, very low.  And this is the rub.  We have too many people able to spend to allow central banks to cease the fight.  Sounds mad?  Absolutely.  We could accommodate this if we were growing productivity but we are not.

The saviour may well be the extraordinary level of household debt.  It’s a complex issue but, in brief, even those households who have no mortgages, appear to have plenty of debt.  It’s likely that property equity has been leveraged into other forms of debt, such as margin loans for stock market investments.  But whatever it is, Australian households are almost the most indebted in the world.

Interest rates also then fall on business and their willingness to invest.  If funds are more expensive businesses do not see a return.  We are playing with fire here because if we have willing spenders and a shortage of goods, inflationary price pressures come into play.  But it isn’t and, as consumer spending contracts, so do businesses.  And part of that business shrinking may well involve shedding labour.  And as the size of the employed market contracts, so does inflation.

But we have a skills crisis, I hear you cry, how does this reconcile with what you have just said?  There are a couple of points to make here.

Firstly, we have a labour market deficit partly caused by our isolationist policy during the height of the pandemic.  In this area we are playing catch up.  Secondly, the way we measure employment beguiles the public into believing that loads of people are busily beavering away all day every day.

The Australian Bureau of Statistics defines a person as employed if they work one hour or more in the reference week it uses to measure employment.  So employment may not be all it seems to be.  But high levels of employment are partly responsible for volatility on the US stock markets as investors see a strong jobs market as a key reason for the Federal Reserve to keep raising rates.

And governments aren’t helping much either.  Faced with cries of pain from their voters, they are under pressure to provide relief for the “cost of living crisis”.  With typical courage, they are not toughing it out but looking at a variety of ways to give financial help to households.  But that relief then frees up households to spend a bit more, something the central bank is trying to stop.

Just as Mr Punch uses his stick to swipe blindly at everyone around him, so central bank are swiping at anything and anyone with the blunt tool of interest rates.  Books get written about this stuff so Marketwatch in a couple of pages has excessively simplified what is an extremely complex issue.

So you can see it gets messy and unpopular.  The final issue is then, will anyone blink?  Well, most central banks such as ours, the US and the UK, are independent.  But that does not make them immune to political pressure.  We saw that in the US with Donald Trump’s relentless attacks on the Federal Reserve which certainly had an impact on their policy setting.

We all need firm leadership and collaboration between governments and central banks to navigate our way through these dangerous times.  My confidence in this happening is low, but I will be delighted to be proved wrong.  Real leadership is hard to come by these days.

Mr Punch defeated the devil eventually.  Maybe we can do the same thing.

Spring is upon us and, despite a few cold nights, we are having some glorious weather to accompany our wild flower season.  Much as many people frown at the word “chardonnay”, the fact that we produce so much of it says something about our taste.  To celebrate the start of the warmer season, Marketwatch has revisited an old friend, and his favourite chardonnay, produced by the that great Wilyabrup winery, Pierro.  Not the cheapest wine around, but if you are celebrating, this is the go to wine.  Don’t swig it, that’s disrespectful.  Relax and slowly enjoy it and it will repay you in spades.