‘There’s only so much you can charge for soup’ – the myth of ‘cost push’ inflation

Why are prices rising?

One theory is ‘cost-push’ inflation. According to my old Dictionary of Economics, this is:

Inflation induced by a rise in the costs of production of goods and services. Such costs increases may arise abroad and be transmitted through higher prices of imported raw materials…Cost increases may also arise within the domestic economy from firms attempting to increase profits and/or employers to increase their earnings.

This assumes that when costs rise businesses can simply pass this on to their customers in the form of higher prices. But this assumes that customers will be willing and able to pay these higher prices and this may not be the case. The Irish Times recently quoted David Dunne, owner of Knox restaurant in Sligo, as saying there is only so much you can charge “for soup or a sandwich or salad.”

For customers to swallow the rising prices consequent from rising costs that ‘cost-push’ inflation requires, they have to have money available to cover these higher prices without reducing consumption elsewhere — if they did that, the net effect on the price level would be neutral and there would be no inflation.

And this is where we come to the real driver of inflation: expansion of the supply of money relative to the goods and services available to spend it on. Only if that happens can customers swallow the rising prices consequent from rising costs that ‘cost-push’ inflation requires.

But this means that the increase in inflation is not caused by some mysterious increase in costs but by an expansion of the money supply: indeed, that might be what drives the rise in those costs in the first place.

The theory of ‘cost-push’ inflation might not hold up to scrutiny, but it guides policy to an alarming degree. The ‘wage-price’ spiral is a variety of ‘cost-push’ inflation and is no more useful a concept. Yet, policymakers are guided to a large degree by the idea that if they can reduce the rate of wage increases, they can bring down the rate of inflation.