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 respected economists 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…