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A little bit of inflation can be a good thing

12 January 2018

A little bit of inflation can be a good thing.  The Monetary Policy Committee of the Bank of England was given a 2% inflation target by the government, so clearly they would concur, but does this still ring true? 

Central banks target inflation to encourage rational economic behaviour as falling prices, or deflation, could very well see consumers hoard cash and delay purchases in anticipation of cheaper prices. This mind-set could be harmful as delayed expenditures slow the economy and could ultimately lead to a recession if they become widespread. On the other hand, if prices rise too fast, it erodes the value of investments which could constrain consumer spending if it outpaces wage increases. In reality, getting the right balance may prove difficult.  

Inflation that is driven by demand may be a sign of a strong economy that may justify higher rates to prevent consumers spending their future earnings today but extraneous factors may induce inflation that is not demand-driven.  The post Brexit devaluation of the pound is just such a case, as was the rise in oil prices in the 1970s. At such times, an interest rate rise to counter inflation may be undesirable.   In the UK, the economy has been lifted on the back of a lower pound but the Brexit uncertainty overhangs the economy.  The Bank of England resisted rate rises, although with unemployment low and inflation well above target they finally felt able to act at the end of last year. Nevertheless, they are still only predicting very small rises in future.  Inflation has been running ahead of wages in the UK, which puts some further constraint on the economy.  In the seventies, powerful unions demanded inflation busting wage increases. These often put struggling companies out of business.  As a result, we had a stagnating economy and rising inflation, also known as stagflation.

It is therefore important to look through temporary effects to see where inflation is coming from before reacting.  The MPC do this by having a target that looks ahead and hence they have the leeway to ignore short term moves. After all, if we had a disruption in oil supply from the Middle East which pushed fuel prices sharply higher, raising interest rates in response would only add to the pain for consumers. The US Federal Reserve has a broader and less explicit target encompassing full employment and stable prices, which may be a better way for a central bank to function. 

If inflation comes from rising housing costs as a result of a lack of supply this may sharply constrain consumer spending.  Raising interest rates to cap house prices will lead to higher mortgage costs thus stemming consumer spending in other areas. This problem may be better dealt with by increasing supply or tightening lending conditions (as they have done in this recovery cycle), rather than raising base rates.

On the other side of the coin, we have deflationary price pressures from a global supply chain and enhanced technology, reducing costs.   In recent years, this has kept inflation low at a time when economic growth as a whole has been positive.  As a result, inflation has been stubbornly below target and central banks have been slower to raise rates than the strength in economy could have allowed.  This may mean they have less room to ease if we have another recession.  In this respect, the US Federal Reserve who are more advanced in their tightening cycle may be in a better position than other central banks.

In short, some inflation is a generally good thing as it encourages rational consumer behaviour but beware of too much and look carefully at where it comes from.

 

 

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