Optimal Inflation Rate

  • Yesterday, the ONS reported a jump in CPI inflation to 3.5% for January (from 2.9% in December.
  • RPIX – all items RPI excluding mortgage interest  payments – was 4.6 per cent
  • RPI was 3.7%

graph source: ONS

The record monthly increase in annual inflation is mainly due to the rise in VAT from 15% to 17.5%.

However, rising oil prices and transport prices have also contributed to inflationary pressures rising.

Usually, after a long recession, rising unemployment and increase in spare capacity, you would be expecting a fall in inflation.

– Last year, there was great concern about the threat of deflation. Indeed we could look upon these statistics as a vindication of economic policy – better to have a bit of inflation than have deflation. I would not be overly concerned by these statistics. I would certainly be more concerned if inflation was undershooting the target at this stage.

Indeed, there is a growing movement to change the government’s official inflation rate. For a long time, the somewhat arbitrary figure of 2% was held up as the holy grail of inflation targeting.

However, 2% is not always the optimal inflation target. This is because

Inflation can spike due to temporary cost push factors. Inflation is influenced by volatile commodities like oil. Just before the recession, we had inflation of 5% – which discouraged Central Banks from cutting rates. But, this inflation was more of a temporary phenomena than evidence of excess demand in the economy. In other words Monetary policy needs to distinguish between temporary rises in inflation and a permanent rise in excess demand.

Higher Inflation Rate would give more Room for Manoeuvre. Some economists argue that a target of 2% gives Monetary policy too little room for manoeuvre. E.g. during the current crisis, when inflation fell below the target, cuts in interest rates were ineffective in boosting demand. If we had a higher  inflation target of 3%, we could have had higher nominal interest rates – leaving central banks more room for manoeuvre and therefore less need to rely on large budget deficits.

See: Interview with Oliver Blanchard from the IMF

For example, in the US, unemployment is at 10% and looks set to remain high for the considerable future. Yet, some economists are already more concerned about the threat of inflation rising above 2%.

Low inflation is desirable for promoting economic stability and long term growth, but, what that low inflation rate is, needs careful examination and a degree of flexibility.

Related

The assumption that the optimal inflation rate is 2% could well be wrong and we would be better off with an inflation target of 3%

7 thoughts on “Optimal Inflation Rate

  1. Interesting and informative article. I would like to add few point related to the topic. I write about CPI and RPI, A biggest jump in Consumer Price Index (CPI) measure of inflation had risen to 2.9%, up from an annual rate of 1.9% in November and on the other hand Retail Price Index (RPI), which includes housing costs, rose to 2.4%, its highest level since November 2008. On result, Increase in the supply of money. In future A possibility of increase in interest rate. I think accurate forecast require to stable economy.

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