INFLATION, as Milton Friedman used to argue, is a form of taxation without legislation. Wealth is taken from some people – for example, holders of cash – and given to others – such as those with large debts. The process is stealthy, opaque, unpredictable and undemocratic, badly understood by citizens, and one of many reasons why consumer price inflation needs to be kept in check.
Those who believe that a “bit of inflation is good for us” usually mean one of three things. They may argue that the debt burden is too large, and that a soft default through inflation is better than an outright default. But writing down debt isn’t a free lunch: it forces up interest rates, as lenders begin to charge a higher inflation risk premium. Inflation reduces trust: societies where contracts – including loans – are not upheld don’t perform as well as those where they are.
Proponents of a little “controlled” inflation also sometimes believe that inflation is the only way to cut wages in real terms, and thus to reprice workers into the labour market following a recession. It is clear that some of the unexpected inflation we have seen in recent years did end up pushing down real wages, and thus did help bring down unemployment. But today’s UK labour market has become extraordinarily flexible and many of the wage rigidities of yore have been eroded. Policymakers need to focus on ensuring labour market flexibility, not on trying to fool workers with bursts of inflation which will eventually lead to inflationary wage spirals or increased risk. There is a good reason why real wages have fallen and workers didn’t respond to the recent bursts of inflation – productivity is down, which means that workers make less and earn less. That is the reason why, until recently, nominal wages hadn’t started rising noticeably; but with productivity finally improving slightly, pay rises will return.
The third reason some cite when arguing for the positive side-effects of inflation is that it helps corporate profits by allowing them to increase prices. But while the markets do appear at first sight to obsess with nominal, not real, earnings, that is in fact not so. Over time, what matters is a company’s relative performance compared to that of its peers – and therefore the impact of inflation is priced in. We’ve all met business people who genuinely believe that their companies are better off when all prices are rising – but they are wrong.
So it is good news that the silent thief – as inflation has also been dubbed – is losing its ability to pick our pockets. Consumer price inflation is down to 1.6 per cent, compared with peaks of over 5 per cent during the crisis; the retail price index measure has dropped to 2.5 per cent. Combined with increasing pay in nominal terms, especially in the private sector – and watch the fresh figures out this morning – the decline in inflation means that real wages have now started to go up too.
A few years ago, at the height of the pre-crisis macroeconomic consensus, falling consumer price inflation would have suggested that monetary policy – then viewed exclusively as interest rates – should stay on hold, or even be cut further.
Yet that was a shockingly short-sighted approach: when there is too much liquidity in an economy, we should not just watch the prices of goods and services but also those of assets. In our contemporary, highly competitive and flexible economy, it appears that inflationary pressures now focus on asset markets. There are many reasons why house prices are rocketing, especially in and around London, but monetary policy is certainly one of them.
With nominal GDP growing at a healthy rate, and every other indicator suggesting continuing strong growth and declining spare capacity, monetary policy should be tightened, regardless of what is happening to the consumer price index. The Bank of England’s targets didn’t work during the bubble and they aren’t working now.