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My mind was elsewhere

18 October 2011 By Edward Hadas

Back in the 1960s, many economists and central bankers considered 5 percent a reasonable inflation rate – high enough to stimulate consumption and job creation without creating too many distortions in economic behaviour. But times change. Now no self-respecting central banker in a developed economy would ever speak warmly in public about inflation at this level, especially when the policy interest rate was just about zero. In private, though, some members of the UK’s Monetary Policy Committee might not be unhappy to see September’s 5.2 rate of consumer price inflation.

The MPC, which just approved another 75 billion pounds of money printing, can explain that the high rate is temporary, that disinflationary pressures will predominate by early 2012 and that its stimulative monetary policy is required to keep the inflation rate from falling and then staying well below the 2 percent target for a long time. Whatever the strength of these arguments, they conceal the most persuasive reasons for tolerating – or even welcoming – high inflation.

The relatively slow recovery since the financial crisis – GDP is still 5 percent below its pre-crisis peak in the fourth quarter of 2007 – means that the real resources available to service and pay off the nation’s debts are not in ample supply. Inflation stretches those resources: the same goods and services produce more money for companies and consumers. That stretching is particularly valuable now, when government austerity is putting a brake on the pace of GDP growth.

Inflation has other advantages. As economists a half century ago used to point out, it is a more palatable way to reduce real wages than nominal pay cuts. In the over-consuming UK, the BoE will welcome that drag. Higher inflation also makes real interest rates more negative. That is rough on savers, but basically makes life easier for financial intermediaries.

All this is well and good, but even those who welcome high inflation should not forget that price instability often leads to economic instability – and sometimes to political crises. When inflation got out of control in the 1980s, the required remedial action – aggressive monetary tightening – was intensely painful. And that is why central banks subsequently decided that 5 percent inflation was in the danger zone.


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