Time to rethink inflation?

Inflation has been made into a bit of a monster by economists but does inflation deserve its bad name?

Inflation is seemingly innocuous and a bit boring. Prices go up over time without hardly anybody noticing or being able to do anything.  But the experiences of stagflation, when the economy stagnated but inflation was stubbornly high in the 1970s, made inflation public enemy number one for economists.  Even though the global financial crisis has shown that there are far worse gremlins lurking in the economy, worries about inflation are hardwired into the way economists look at the world.  Does inflation still matter or should central banks be keeping their eyes out for something else?

Inflation has been targeted by policy makers since the 1970s when economies in the West were plagued by high inflation and slow economic growth amid the effects of the oil shocks.  Inflation became a central part of a downward economic spiral – rising prices for consumer products due to oil being more costly prompted unions to demand higher pay which pushed up the costs for firms, to which they responded with increasing the prices of their goods. The negative impact of rising prices and wage increases in combination with the higher cost of oil devastated the economy and created a link between economic stagnation and inflation – hence the term “stagflation”.  A turnaround came on the back of the unions losing their power to influence wage negotiations after standoffs with Margaret Thatcher in the UK and Ronald Regan in the US.  But inflation is the boogie man than has given a generation of economists nightmares.

The trauma of stagflation was powerful enough for politicians to give up control of monetary policy to independent banks which was seen as the best means by which to keep the beast of inflation in its cage.  This policy has been successful in that inflation has remained subdued over the past two decades with expectations of low inflation translating into only incremental increases in wages.  This new policy was aided by the development of China as source of cheap labour and an exporter of low cost goods which limited increases in both prices and wages.  Despite achieving what it set out to do, the new policy framework also created new problems.

Central banks have focused on slaying the beast that is inflation but choose to ignore higher prices in other areas such as assets like houses or stocks.  Higher prices for assets have the potential to develop into asset price bubbles which when popped can have a devastating effect as shown by the global financial crisis.  Whether it be because asset price bubbles are not always easy to spot and this would create considerable subjectivity in policy making, central banks have typically shied away from acting to prevent the build-up of asset price bubbles.  Inflation in terms of prices of consumer goods is easier to measure and develop a consensus on the correct policy measures but this may be a case of slaying one dragon only to let a bigger one roam free.

Your Neighbourhood Economist would argue that inflation is not the scourge that it once was.  Relentless increases in wages as in the 1970s are not likely to occur as unions do not have anywhere near the same power as before and also because competition from workers in China and elsewhere means that average wages in Western countries have hardly seen any increases at all.  So the past lessons from stagflation do not seem so pertinent any more.  The global financial crisis occurred at a time of low inflation but following a period of excessive lending by banks spurred on by low interest rates set by central banks.

This does not mean that inflation is something that should be let loose again.  Rising prices eat away at what workers can afford to purchase with their wages and they will be able to buy less with their savings that are stashed away if prices are increasing.  Inflation in one country also increases the costs used to produce goods in that country and makes it less competitive relative to goods made elsewhere.  But to have monetary policy revolve around something that has only a minimal effect on the overall economy is out-of-date and potentially hazardous.  Inflation may also be a route to salvation for Western countries buried under high levels of debt – it is easier to pay back loans if wages and tax revenues are increasing (for more on inflation as a power for good, see What's up with inflation?).  It will take a lot for economists to admit that they have gotten side-tracked by an infatuation with inflation, but the aftermath of a near economic collapse seems as good a time as any to do so.