Contemporary politics sometimes seems to be largely focussed on inflation. As the current cost-of-living crisis has shown, inflation can be both disruptive and harmful to our general wellbeing. However, governmental interest in constraining inflation long predates the current crisis, so its worth asking what is the matter with inflation?
Certainly, a lot of effort goes in to trying to control it. One of the key roles for central banks (in the UK’s case, the Bank of England) is to control inflation. This is usually done through the bank’s ability to control the interest rates that banks charge on new and (many) outstanding loans. For most of us, the way we experience this is through the interest we pay on our mortgage, or more precisely how it changes over time.
‘Normal’ inflation and market economies
The Bank of England does not try to reduce inflation to zero. Instead, the Government sets it an inflation target; currently and for some time the target has been around 2%. So, firstly it is clear that some inflation is perfectly acceptable to policy makers; why?
The Office of National Statistics uses a basket of goods and services to measure inflation. Examining this basket, it is clear that not all prices are going up at the same rate. Food price increases are currently around twice the current headline rate of inflation, but also there are some goods and services that even now have remained at the same price, or are seeing price reductions.
Therefore, the reason that normal inflation is seen as helpful is it allows the shift in relative prices between goods and services to take place without disturbing the more general balance of consumption. There are various reasons why these shifts might happen, such as the introduction of new technologies, improvements in quality or changes in consumer habits.
As the relative prices of goods and services change, some remain stable (effectively becoming relatively cheaper), while others outstrip the headline rate of inflation (becoming more expensive in real terms). An inflation target of around 2% allows this to happen without the need for many prices to be reduced (we’ll come back to the problem of deflation below).
Who is most worried about inflation?
When inflation goes above the ‘normal’ rate, governments often become vexed by the problem of rising prices. They also become concerned about the impact it might have on workers’ demands for higher wages. The question is: whose interests does this really reflect?
For those who owe money, inflation can be quite helpful because it reduces the relative value of the amount borrowed. Indeed, the general advice to push your mortgage to the maximum you can afford reflects the long-term high rate of inflation in house prices. The rise in the price of your house progressively reduces the proportion of its value accounted for by your mortgage.
This is why, despite it technically being inflation, rises in house prices are often welcomed and referred to as ‘house price growth’ even as they price those without houses (first time buyers) out of the market in some areas. Indeed, if you own your house or other property with no mortgage, inflation offers an increase in your nominal wealth.
Conversely, for those who have lent you money because they accumulated it as private citizens or as financial institutions, in other words savers, inflation reduces the value of their monetary asset.
In normal times, we would expect this reduction to be covered by the interest charged on any loan they make. But in times of high inflation, this is not the case because inflation accelerates quicker than effective interest rate payments can, and so the lag results in real (inflation adjusted) losses: the loan’s repayments of interest and capital cannot keep up with the reduction in value caused by inflation.
So perhaps unsurprisingly, those who are most worried about inflation rising above the ‘normal’ rate are those with cash in the bank. While we should all be concerned about very high levels of inflation (such as we are currently seeing in food prices), even moderate inflation is a major concern for the cash rich. It is this group who express disquiet when inflation rises above the normal rate, but has as yet not reached a hyper-inflationary level.
Equally, for employers seeking to maintain margins, the increased wages demanded by workers to maintain their standard of living may also be unwelcome. For some economists this can result in a wage-inflation spiral, with each pay increase feeding into price rises by raising firms’ costs.
However, when the costs driving price rises derive from elsewhere (at the moment this means primarily the price of energy) the link between wages and inflation is much weaker. Moreover, unless we take into account companies’ desire to increase their margins, to lay all the blame for inflation on wage rises, obscures the role of increasing profits in rising prices.
In the UK, over the long-term business leaders and financiers have often not only been influential on governments, but have also ended up in government themselves. It should therefore be no surprise that their desire to control inflation has shaped much economic policy making.
How interest rates impact on inflation
The main instrument governments use to respond to this concern about inflation is their control over interest rates via the country’s central bank. When the central bank increases interest rates two things happen.
Its own bonds become more attractive to investors (because they are risk free) and therefore investors at times of uncertainty find them preferable to other investments. This then lessens the amount of money available for other purposes including commercial opportunities that are (by definition) riskier than lending money to the Government. The attraction of low-risk investments reduces the available money in the economy because it makes it difficult, and expensive, for firms to raise the working capital they need.
This also forces all other banks to raise their rates to attract short-term funds for deposit; they have no choice in order to protect their central capital holdings, which form the base of their operations. So the second effect is to make borrowing more expensive, making both new and existing variable rate loans more expensive. Again, this reduces the amount of money available for the borrower to spend as the increased interest repayments crowd out other expenditure.
The aim is to reduce the amount of money chasing goods and services, and because prices (in a general sense) respond to demand, a reduction in demand eases inflationary pressure. Think about house prices; where more people are seeking to move to an area (raising demand), prices rise, and conversely where fewer people wish to live prices remain lower. Interest rate policy seeks to engineer a reduction in prices by reducing demand.
However, especially in the complex loan environment of modern banking, these effects can take some time to surface. The danger is that by the time they do start to depress economic activity, inflation has declined for other reasons, and so the policy ‘over-shoots’, driving the economy into a depression or even a deflationary spiral.
The problem of deflation
So, finally, lets return to the issue of widespread decline in prices; the problem of deflation. You might think that if inflation is a bad thing, then deflation (a generalised drop in prices) would be welcome. However, as periods of deflation have shown, it can become a self-fulfilling decline. Once it is clear prices are falling generally, consumers often decide to wait to purchase key (and large) items until the price has dropped further.
While this may make sense for the individual, for the entire economy it can mean a drop in demand. This then can trigger a vicious circle of further price reductions as firms try to encourage consumers to make delayed purchases, which merely confirms in consumers’ minds the wisdom of waiting a little longer.
Deflation can reduce economic activity, squeeze margins and lead to firms seeking to reduce wage costs. Equally, as we have seen when house prices fall, it can leave borrowers with loans that are more than the asset which was purchased (negative equity), again leading to economic problems.
As with so many things, inflation in moderation is fine. It is when it gets out of hand that troubles mount up. However, when we start to look at how to control inflation, the costs of control do not fall equally on all of society.
We are frequently told that the measures taken to control inflation are ‘a price worth paying’ to restore stability, but given who is paying the price (in higher interest rates) and who is most worried about inflation, we should never forget that the choice to have very low inflation in any economy is a political choice.
No-one wants, nor really benefits from runaway inflation but the choice of an acceptable rate and the policies to maintain it, involves (like all economic policies) trade-offs that are seldom made explicit!