Wednesday, May 20, 2009

Is Inflation Really So Bad?

Many have been told dire stories of German hyperinflation in the 1920s causing economic upheaval, the rise of Hitler e.t.c. Because of events such as this and in Zimbabwe, there is a strong assumption that inflation is always and everywhere a serious economic problem.

Low inflation (of around 2% ) is indeed the primary economic target of all major economies. Everyone assumes inflation is bad, but, how really damaging is it if inflation rises above the inflation target?

Let us assume that inflation was to rise above 2% closer to 6 or 7% what would be the economic consequences?

Potential Costs of Inflation

Inflation reduces value of savings. High inflation reduces the value of money. Therefore people who keep cash under the bed will see their savings decline. But, who actually keeps money under the bed? If interest rates are higher than inflation then the real value of money will be maintained. Inflation of 7% and interest rates of 9%, is much better than the current situation of inflation 2.9% and interest rates of 0.5%. (which is a negative real interest rate). It is not the inflation rate that determines real value of savings but the real interest rate.

Inflation makes people worse off. Higher prices increase the cost of living. Again the key issue is whether nominal wages keep up with rising price level. As long as real wages remain positive people will not be worse off. All state benefits are index linked meaning that higher inflation will lead to bigger rises in benefits.

International competitiveness. A higher UK inflation rate causes UK goods to become uncompetitive. However, the inflation will also cause a depreciation in the value of pound restoring the competitiveness of exports.

Confusion and Uncertainty It is said high inflation rates create greater uncertainty and confusion leading to lower levels of investment. Alot depends on whether the inflation is anticipated or unanticipated. If inflation is anticipated the impact on uncertainty is much less.

Menu costs. Higher inflation rates mean firms will have to readjust prices more frequently. But, with modern technology it is easier to do.

The Spiral Effect. The big fear of inflation is that a moderate rise in inflation rates causes inflation to inexorably spiral upwards. If we allow inflation to rise a little, before we know it we are facing a real problem with inflation in 3 digits. In practise it is hard to control inflation once it starts to get out of hand. Therefore, its best to keep it low


Targeting low inflation does make sense. By targeting low inflation we can provide a framework for sustainable and stable economic growth. It helps avoid boom and bust cycles which are very damaging.

However, maybe some Central Banks (in particular the ECB) could loosen up a little and not feel so guilty if inflation slightly overshoots the target. Many years ago, Norman Lamont told us 'unemployment is a price well worth paying for lower inflation' but, maybe this assumption is misplaced and not true. Whilst inflation does have costs, there are potentially much bigger costs of dogmatically targeting low inflation, especially in the current climate.

Also another lesson of this recession is that targeting low inflation is insufficient to maintain macroeconomic stability. The low inflation of the early 2000s seems to have given us a false impression of economic stability.

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دخترک ژولیده said...

You said that higher levels of inflation brings uncertainty and thus lower investment, what if people expect the inflation rate to rise in the future?

Tejvan Pettinger said...

An expected rise in inflation is likely to cause increased uncertainty. e.g. how much will inflation increase e.t.c

Ammo said...

Consumer price Inflation targeting is easily demonstrated as nonsense, which disregards savers by acting to keep the real rate of interest they should be getting on thier money lower than it would be, creates asset/'investment' booms and leads to a debt engorged slump.

On Deflation: If manufacturing costs come down because of a technological breakthough in energy costs for example, that would sharply lower goods prices producing deflation below the 2% target rate?. Does that mean the central bank should react by printing money and lowering interest rates further to punish saving and encoraging debtors?

Inflation: If there is a inflationary shock due to natural disasters etc.. does that mean the central bank has to remove money, raise real interest rates and create unemployment to achieve its inflation rate?

What about asset prices? When people cannot afford housing because the central banks interest rate under consumer goods inflation targeting of 2% has been held low for so long, meaning massive inflation in houseprices and credit growth.

If consumer goods inflation takes off due to the bursting of a asset bubble through a sharply lower currency exchange rate, while at the same time houseprices collapse does that mean a higher interest rate should apply - due to consumer inflation targetting?

The main weakness of inflation targetting is that it implies that the only source of financial instability is consumer price inflation or deflation. Totally ignoring asset price inflation, or consumer debt levels, savings and investment, trade deficits etc...

Surely what is needed is instead a 'real rate of interest' target, which could act to prevent asset inflation and massive destructive credit bubbles.

Philip said...

You say "It helps avoid boom and bust cycles which are very damaging"... is this true... look around all of nature, and even the universe itself. It is cyclical. Perhaps this is the way to avoid complacency, to flush out the low performers and let the strong flourish. Otherwise, we end up with a moral hazard... it doesn't matter if I fail, cause there's always the good ol' gov't to bail me out.