Don't fear inflation

Watch out. The figures are in: inflation in December shot up to 3.7 per cent.  Soon we will be hearing calls for the Bank of England to raise interest rates. Pray the Monetary Policy Committee is wise enough to resist. If not, they will doom us to higher unemployment and a double-dip recession.

Our economy remains much too fragile to weather higher interest rates. For the past two years, fiscal policy and automatic stabilisers provided a counterweight to shrinking private sector demand. But the government’s new austerity programme will soon remove that needed crutch. With fiscal policy becoming contractionary, monetary policy must not. Imagine the effect on house prices if interest rates shot up.

Since it is the interests of the financial sector that dominate conventional economic thinking, we have been hypnotised into believing that inflation is always terrible. This is a mistake. The fundamental reason the Bank of England should maintain low interest rates in spite of the December figures is that 4 to 6 per cent inflation is precisely what our stagnant economy needs. Indeed, increasing numbers of respectedeconomists are calling for central bankers to raise their inflationary targets. How can higher inflation be a good thing? Three reasons.

Since the credit crunch, central bankers have tried to stimulate the economy in the traditional way, through monetary policy. Yet demand is so weak that even dropping interest rates to almost nothing has not been enough to spur a strong recovery. Since nominal rates can’t go negative, central bankers are up against a wall. But since higher inflation allows the real interest rate to go below zero (real interest rate = nominal interest rate – inflation) inflation gives monetary policy the necessary scope to be effective.

Second, inflation stimulates demand. The easiest way to understand this is to look at the effect of deflation. A deflationary spiral is so destructive because consumers continually put off purchases since they expect prices to fall. As purchasing slows down firms lay off workers, which further reduces demand, causing prices to collapse even more, ad infinitum. Higher inflation, since consumers expect prices to rise, gives us an incentive to buy now, and that is precisely what our economy needs today.

But the biggest reason to welcome inflation is that in real terms it lowers the cost of our debts.  Remember, we have been in a balance sheet recession.  Households and firms aren’t buying because we have been busy paying off debt incurred in happier days.  It is this debt overhang that keeps us from spending and thus keeps firms from hiring.

Inflation allows us to repay our debts in depreciated currency. By lowering our debt burden and raising the value of real—as opposed to monetary—assets, inflation reduces the strain on our personal balance sheets, raises our equity, increases our wealth and so gets us spending.  Higher inflation is not the problem, it can be the solution.

Yes inflation has its costs. It hurts those of us on a fixed income.  It penalises savers and subsidises borrowers. It naturally strikes us as unjust since the flighty grasshopper gains while the hardworking ant suffers. But like most economic phenomena, it creates both winners and losers. Keynes tells us that entrepreneurs, almost always net borrowers, are among the winners.  Net lenders, i.e. the banks, are the losers.

If you are a banker, if you make your living lending money, then inflation, which allows your debtors to repay you with cheaper money, is indeed worse than the black plague. But for the rest of us, inflation is far less painful than ever-rising unemployment. Let's hope the Bank of England recognises the present dangers of recession far outweigh the possible future costs of inflation.