Monday, January 24, 2011

Inflation in the 1970s and 2000s

inflation

UK Inflation in 60s and 70s.

Recently there have been quite a few newspaper articles talking about the 'horrific' inflation of 3.7%. Actually, if you look at Core inflation, CPIY (inflation - taxes) it's not quite as horrific as 3.7%.
  • Many people make the comparison with the 1970s, when an oil price shock caused inflation to rise to double digits. However, there are notable differences with the 1970s.
  • The 1970s didn't see an asset price recession with banks reluctant to lend and a significant amount of spare capacity.
  • In the 1970s, rising wages were a very important factor in causing a wage price spiral. There is no evidence for rampant wage inflation, - just try asking anyone in the public sector about rampant wage inflation and they will give a wry smile.

Worse Trade Off.

Like the 1970s, we are experiencing a worse trade off. We do have higher inflation and prospects of a slowdown in growth.

If the Bank of England really wanted to target CPI inflation of 2%, they could do. But, if they raised interest rates to reduce inflation, it would mean a trade off of lower economic growth.

However, even without interest rate increases, it is forecast that economic growth could slump to as little as 0.1% per quarter; with this growth rate, spare capacity and unemployment will continue to rise. It doesn't make sense to inflict more economic pain with such feeble growth forecasts.

stagflation

Graph showing combination of high inflation and falling output.
It should also be remembered the inflation target of 2% is not the ultimate goal of economic policy. Savers may say it is not fair inflation is above base interest rates, leading to a decline in real savings. However, would it be fair to increase interest rates rapidly causing a second recession and keep three million out of unemployment?

Unfortunately, there is a situation where something has to give. We can't have both low inflation and full employment. We need to accept this and make a sensible choice between the different choices.

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