Dealing with inflation

Readers Question: Given that inflation has distortionary effects on the economy, Should the government pursue a deflationary policy?

Inflation has various costs.

For example:

  • It creates uncertainty and confusion; this can lead to lower levels of investment.
  • It can distort asset markets. Ultra low interest rates make it cheap to borrow and therefore encourage investors and speculators to buy assets like houses. This can lead to an asset boom. For example in the years up to 2007, ultra low interest rates led to a boom in house prices especially in US, Spain and Ireland. However, this house price growth was unsustainable and led to a bust. This bust was a major cause of the financial crisis and economic recession.
  • Inflation reduce the real value of savings and income, especially if interest rates are low and nominal wage growth low.
  • See more costs of inflation

Should the Government pursue deflationary policy with inflation above target?

Usually, yes. The government seeks to keep inflation low to avoid the costs of inflation. If growth is too fast, then increasing interest rates can moderate growth and keep it sustainable. This prevents a boom and bust and can prevent recessions.

Is there a situation where government shouldn’t pursue deflationary policy?

Possibly:

  • Inflation is temporary – e.g. due to taxes, due to rising commodity prices
  • Inflation is Cost push – rising costs can lead to higher prices and lower growth.
  • If underlying ‘core’ inflation is increasing, then there is a much stronger case for increasing interest rates. (See different types of inflation)

The UK example presents a good case of allowing a rise in CPI inflation without pursuing deflationary  policies. During period 2011-13, UK inflation was mainly due to temporary factors (higher tax, impact of devaluation on import prices). But underlying inflationary pressure was low because of sluggish economic growth.

inflation-interest-rates

Also, the UK government is pursuing deflationary fiscal policy – through higher taxes and lower spending. This means the MPC is delaying increasing interest rates.

It was very unusual in 2011/12 to have a situation where headline inflation CPI is 4%, and interest rates 0.5%. It reflects the unusual situation where we have temporary inflation and a sluggish recovery.

Yet, some in the MPC, still felt with inflation reaching 5%, interest rates should have increased.  (reasons to tighten)

How to deal with inflation

  1. Monetary policy (primarily use of interest rates). Higher interest rates increase cost of borrowing and generally discourage spending and investment, leading to lower rates of economic growth
  2. Fiscal policy (e.g. higher tax and lower government spending). This helps to reduce AD. Usually fiscal policy is not used to tackle inflation because it is hard (unpopular) to increase tax rates just to reduce inflation.
  3. Inflation targets / independent Central Bank may increase credibility of monetary policy.

More detail at:

By on February 28th, 2011

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