Inflation - is there no middle ground?

6th December, 2010

  • In this challenging economic environment, we tend to be increasingly concerned by commentators’ views on the potential impact of inflation. Will we see a return to the hyperinflation of the 70’s or do we face a period of deflation?

    Given the impact that both upward and downward movements can potentially have on our overall economic health and our personal wealth, it is hardly surprising that we are taking a keener interest than ever.

    Most of the expert commentators seem to consider only two possible outcomes of high inflation or deflation. Is it just me or is there a distinctive lack of middle ground views being expressed in this important issue?

    According to the Bank of England, the remit of the ‘wise men’ on the Monetary Policy Committee (MPC) in setting interest rates is to achieve an annual inflation target of two per cent, based on the Consumer Prices Index (CPI). Further, it is clearly stated that they are not attempting to beat the target as they consider inflation below the target to be just as bad as inflation above the target.

    So given that this target is symmetrical, why are the commentators so polarised in their views of where we will end up with inflation? Could they be tactfully suggesting that the Bank of England isn’t going to do its job properly and, with opinion split so evenly, are they perhaps implying that it’s a near impossible job?

    Also, where does this wide disparity in inflation predictions leave the rest of us who are looking for some kind of clarity on the issue so we can make informed decisions about the likely effect this will have on our personal finances, our businesses and our pension schemes? And should we accept that the impact will be, as the commentators seem to suggest, one extreme or the other?

    Looking at some of the pronouncements made by the Bank of England, I have my own thoughts on this issue:

    1) According to the Bank, “low inflation can help to foster sustainable long-term economic growth”. I note that they talk of ‘low’ inflation, not zero inflation. We should therefore accept that a small rise in inflation is considered ideal in securing economic growth.

    2) The Governor of the Bank of England, Mervyn King, admits that inflation will be above target throughout 2011 and that bank rates will not rise soon. The Bank also states that the maximum impact of a change in interest rates on consumer price inflation takes up to about two years to come into effect. The current historically low bank rate of 0.5% has been in place since March 2009 and there are no signs of it being increased. Surely this will only add to inflationary pressure in the coming months and the effects will continue to be felt for some time beyond 2011.

    3) In March 2009 the MPC announced its decision to inject money directly into the economy through quantitative easing. Last month, in the US, the Fed announced a further $600bn of QE, leading to accusations of exporting inflation abroad. In Europe, various options are being considered in an attempt to prevent contagion in EU financial markets. While no one quite yet knows what the impact of these actions will be, like the setting of interest rates, one might expect a lag effect on inflation and on the upside.

    4) Final thought – which is the least worst option between high inflation and deflation? Whilst neither are welcome, unfortunately, whether we know it or not, our personal and national debt levels are so high in the UK that the pricing effect of deflation would be catastrophic, not to mention the likely recession and unemployment that would likely follow.

    I therefore believe that the wise men at the MPC will continue to aim at their symmetrically-balanced inflation target but with a bias to the upside – although I don’t expect them to acknowledge it – and ultimately I think that their tinkering will lead to a significant overshoot on the inflation target.

    To finish, here’s my ‘get out of jail free’ card, courtesy of Mervyn King: “Cycles in real activity sometimes reflect behaviour outside the influence of monetary policy.”

    Perhaps his words underline why the commentators are right to rule out a middle ground destination for inflation as the MPC’s job is just too hard, the financial world is entering unknown territory and the only outcome we can rule out is the one that comes near to the inflation target.

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