The Inflation Enigma

Not exactly a title designed to excite but it is worth a few moments of consideration.  At the intersection of wages, prices, interest rates and economic growth, inflation is one of the key barometers of economic health and central to the management of economies.

Some inflation is regarded as essential to maintaining economic growth by encouraging production through rising prices, thus encouraging employment which in turn stimulates demand and then more production and hence more employment.

There is history to this.  Deflation, the contraction of money in circulation with consequent downward pressure on prices (too little money chasing too many goods), was seen as a major cause of the Great Depression, combined as it was with high unemployment.  The great economist John Maynard Keyes argued that lack of demand was at the root of the problem and set out the case for putting money into the economy to kick start growth (known as pump-priming).  His expansionary monetary policy was regarded by conservatives (the kind that liked to link currencies to the gold standard) with some horror but it has become a major tool in the management of economies.

Yet expansionary monetary policy (not least because of wartime spending in the 1930s and 1940s) worked back then and it worked recently to overcome the financial crisis.  US Fed chairman Ben Bernanke (who had studied the Great Depression) and Mario Draghi, President of the European Central Bank, engaged in “quantitative easing”, pumping dollars and euros into their economies.  The Fed took on some $4.5 trillion worth of assets onto its books as part of this expansion of the money supply.  The ECB set up an initial $640 billion loan fund (some years behind the US because Draghi’s predecessor Jean Claude Trichet, had controversially hiked interest rates and resisted quantitative easing). The balance sheet of the Eurosystem (the ECB and all 19 central banks in the Eurozone) was $4.4 trillion as of last year.

Increasing the money supply eases credit by making money cheaper and lower interest rates are a key to boosting demand by expanding the consumer’s capacity to borrow and buy stuff.  When the financial crisis hit, the problem was that interest rates were already low so the authorities had to go to historic lows.  Japan went so far as to set a negative interest rate, meaning that your money eroded in value if you kept in savings rather than in use through purchases or investment.  (The ECB did the same for one category of bank rate).)

The Bank of England acted similarly in the face of Brexit last year.  After the referendum and expecting an immediate economic hit, the BoE dropped the interest rate (to 0.25% for banks) and boosted the money supply by £70 billion. It worked in the short term but by lowering sterling it has encouraged price inflation which, with wages stagnant, will ultimately lower demand.  We can see this happening now. I think the judgement of history on this intervention will be mixed but it let the BoE say it was doing its bit to help.

Historically too much money could mean that things got out of hand, causing rampant price inflation (too much money chasing too few goods): to keep up with prices, the authorities print more money and undermine confidence in its value, leading to hyper-inflation.  The phenomenon brought down the Weimar Republic and helped usher in the Nazi regime. It happened again in Zimbabwe in the 1990s, peaking in 2008 with literally astronomical inflation measured in the tens of billions, leading to the abandonment of the currency in 2009 in favour of foreign currencies.

Central Banks have since the end of WWII pursued a careful balance between price stability and economic growth capable of sustaining full employment (around 4% unemployment). The sweet spot or target rate is regarded as around 2% inflation. Economic theory sees a direct connection between employment and inflation: as employment rises, so do wages (thanks to competition for labour) leading to price increases.  The converse is held to be true too and the inverse relationship between unemployment and inflation is known as the Phillips Curve.

In the face of the financial crisis and economic slow down, the actions of the US Fed and ECB in expanding the money supply worked, though it took longer than anticipated (and the ECB moved slower than the Obama administration).  Both the US and Eurozone economies are now growing and unemployment dropping.  Ireland was one of the first to recover and now Portugal, Spain and Italy are looking at growth in excess of 1%.

With full employment and little productive slack in an economy, one can expect wages to rise, the amount of money in the system to increase, and upward pressure on prices; in short inflation.  In response, central banks would typically tap the brakes by raising the interest rate (the price of money), encouraging people the save or invest in say government bonds, thus reducing the volume of money in circulation and easing price inflation.

This is in fact what the US Treasury has just announced.  It will start selling off the assets it brought to flush money into the US economy and will start slowing and carefully raising the interest rates.  The ECB is likely to follow suite but like its beginning will be wary about its end, with tapering rather than finality, the better to preserve some flexibility.

In some ways, a rise in interest rates would be a good thing.  Yes, you will point out, public debt servicing increases, credit is more expensive and mortgage costs go up.  This is why it is politically unpopular and why governments are always keen to keep interest rates down. But by putting a price on money like a decent interest rate, you are imposing some discipline on how money is spent: an investment must yield a better return that a savings account.  When interest rates are near zero, money sloshes around the global system and virtually any investment looks good.  Savings – normally a sign of prudent household manage – are discouraged.  Pension funds find it difficult to make a return.  In the allocation of resources, putting some price on money is a good thing.

Above all, those in charge of monetary policy in central banks like the BoE, ECB and US Federal Reserve – safely out of the reach of direct government influence and protective of their autonomy – want to guard against runaway inflation and while mindful of governments’ concerns, will ultimately choose to increase interest rates if they detect inflation heading above the target rate.  Moreover, increasing the interest rates when times are good gives central banks some leeway to reduce rates when things slow down, helping to even out the highs and lows of the business cycle.

By now looking to a series of interest rate increases, the US Treasury is betting on a return of inflation. All the classical economic theories say we can expect this.

Yet inflation theory has become unstuck.  All that quantitive easing should have engendered price inflation.  The fall in unemployment should have added to this momentum. That would have allowed central banks to justifiably pull back on the money supply and increase interest rates.  Inflation however has stubbornly refused to make its appearance.  The ECB is repeatedly disappointed that the inflation target consistently recedes. No one appears to know why.  Deflation has been held off but inflation has virtually disappeared and no amount of employment or quantitative easing appears to summon it into existence.  That is the enigma of inflation today.  Where did it go?

One theory is that the answer to the enigma lies in globalisation. And one test of that theory is Britain’s Brexit experiment in what its own Governor of the BoE has characterised as “de-globalisation”.  More anon.





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