Monday, August 1, 2011

Why We Tolerate High Inflation

Interesting study that says if we had stuck religiously to targetting inflation at 2%, interest rates would have been much higher during past two years.

Using Bank of England's Stimulation Tool, analysis by Fathom Consulting shows that the Bank Rate would have to have been around 3.5pc to 4.5pc since the recession ended in the last quarter of 2009 to have kept inflation within half a percentage point of the target.
But, with these interest rates, the economy would have been in a prolonged downturn.

The study suggests that with higher interest rates, growth would have been close to 0% and unemployment at 10%. It could have been longest recession since 1930s.

However, this analysis ignored the possible impact on the housing market of higher interest rates.
Higher interest rates would definitely have increased the rate of mortgage default. This would have led to more bank losses and lower consumer spending.

Inflation at 4% may be uncomfortable and unfortunate, but I can't see how it is possible to justify keeping inflation at 2% - if it means - a prolonged recession, higher unemployment, and a lower tax receipts (bigger budget deficit)

The Bank of England faced a difficult choice, but they definitely did the right thing in temporarily tolerating higher inflation. (something the ECB could learn from)


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