A little bit of inflation could help us all

By Nik Askaroff

Once again the Bank of England Monetary Policy Committee has kept interest rates on hold.  The Bank's only mandate is to manage inflation below the Government's target of 2% and its only real weapon for this is interest rates.

This remit recognises the role of price stability in achieving economic stability and in providing the right conditions for sustainable growth.  Most of us in the business community would acknowledge the benefits of low inflation but, in these challenging times of our high debt burden, more and more are arguing that a bit of inflation might, in fact, benefit us all.

Interestingly, the Bank now has a role of managing inflation down through interest rates and at the same time stimulating the economy through quantitative easing (injecting money into the economy).  QE was originally introduced when there were fears of inflation falling below its target and interest rates being at such a low level that any further reduction wouldn't be a realistic stimulus.  We now have a position with inflation above target and fears of an interest rate rise, yet talk of further stimulus being needed.

Nobody would want to lose what the Bank has achieved by fighting inflation but, at the same time, we need to avoid a liquidity trap in which banks don't lend and firms don't invest.  For the economy to grow we need to drive down long-term interest rates and boost growth.  The best way to reduce real interest rates would be to let inflation grow.   This has four specific benefits:

? Business growth would be stimulated because you get a better return by investing your money than seeing a negative real return if you save it.  If people fear prices are going to rise, the natural inclination is to buy now rather than pay more later.

? Higher inflation eats away at debt and this is something the country, UK business and mortgage-burdened families could all use at the moment.  A few years of controlled inflation could reduce national debt by far more than any tax increases.

? Inflation is a boost to stock and asset values.  This would not only put profitability and confidence back into the system but would also reduce pension fund deficits and boost pension fund values.  As stock and asset values rise, companies should become more secure.

?Lastly, inflation can massively boost individual and business confidence.  As values increase so will profits and the public's attitude to spending.

Inevitably higher inflation will lead to interest rate rises, but as long as these ‘lag' the inflation rate then a triple benefit of business growth, reduced debt and better returns for savers can be achieved.

In the USA, where growth has stalled and the economy is on the brink of a double-dip recession, there are strong calls for injecting the economy with a healthy dose of inflation.  Central bankers are congenitally obsessed with the dangers of inflation and some argue more obsessed with stable prices than lost jobs.  Some even argue that they focus too much on looking after lenders for whom inflation is generally bad news.

Since the fifties we have experienced 50 years of inflation and generally this has helped to expand the global economy and make us more prosperous.  The intuitive prejudice against inflation in normal times is beneficial and none of us wants to go back to double digit hyper inflation, but in times of crisis we need to consider all options. 

As the Government prepares to announce the highest cuts in Government expenditure and increases in taxes that any of us has experienced, maybe it's time to let a little inflation bear some of that burden.  It will help debtors and spenders in favour of creditors and savers, but if our economy is to grow to replace the lost jobs we have to stimulate the risk takers not the prudent.

Boosting inflation certainly isn't the ‘right' policy, but at this point in our economic cycle, it may just be the correct one!

12 October 2010