Friday, 1 February 2013

What’s up with inflation?

Inflation has been given a bad name but redemption may be at hand as high levels of debt mean developed economies could benefit from more inflation.

Inflation has been treated with the same disdain as smelly socks – an unfortunate factor of life that is tolerable at low levels but too much may be the sign of something more serious.  This stems from periods in history when inflation has wreaked havoc such as when hyperinflation in the 1930s in Germany resulted in prices skyrocketing to levels so high that Germans would go grocery shopping with a wheelbarrow full of cash.  Inflation eats away at the value of savings with higher prices meaning that the same amount of money can no longer buy as much.  But the flip side of this is that inflation also reduces the value of debt.  With the high level of debt among the most pressing concerns in many developed economies, inflation no longer seem so bad and there has been a shift in views that will affect anyone with savings or debt which is almost everyone.

The first signs of a change came from the Federal Reserve which has two goals as the central bank of the United States, low inflation and full employment.  A focus on clamping down on inflation had resulted in employment being less of a concern for the Federal Reserve, but as central banks everywhere have been asked to help out with sluggish economic growth, the Federal Reserve is paying closer attention to the job market in the United States.  In December, the Federal Reserve announced that it would keep interest rates close to zero until unemployment had fallen from its current level of 7.75% to 6.5% or until inflation was forecast to top 2.5% which is higher than the target rate of inflation of 2%.  A key role of any central bank is to signal its intentions so as to manage expectations for inflation and the Federal Reserve has shown that it will be more tolerant of inflation if that helps to lower unemployment.

More creative ideas on monetary policy are coming from the newly appointed governor of the Bank of England, Mark Carney.  Carney achieved almost rock star status after a successful spell (due to skill or good fortune) as the governor of Canada’s central bank and his ideas are raising eyebrows.  Carney put forward the idea that central banks should target nominal GDP instead of inflation.  Typical GDP figures are quoted with the effects of inflation taken out but nominal GDP includes both growth in the economy and rising prices.  This would enable central banks to accept more inflation when the economic growth is slow by setting interest rates to be lower (or monetary policy to be looser) than would otherwise be the case.  While this new policy may be a bit too radial for the conservative world of central bankers, it is a part of Carney’s belief that monetary policy can have more of a role in lifting the economy out of the current stagnation and that there are unconventional policies which could be implemented instead of monetary policy simply aiming for a certain level of inflation.

More inflation will also help governments with high levels of debt.  If prices rise at a faster rate, this will increase the size of the economy in nominal terms and the amount of debt will shrink relative to the economy making it easier to pay off.  And it is not only governments with lots of debt but many households who purchased property during the housing boom are struggling with large mortgages and they too should get some cheer from higher inflation for the same reason.  Inflation will also been a boost to businesses that will have more scope to raise prices and will be tempted to borrow more for investment if interest rates are lower than inflation (also referred to as negative real interest rates).  But inflation has always been the enemy of frugal types (including Your Neighbourhood Economists) who have put money away and savers will be the big losers.  While it is unfair to penalise the responsible, the burden of debt on governments and on the economy as a whole in developed countries is currently so great that calls for more tolerance of inflation should be heeded.  Inflation need not be so bad after all.

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