The Much Anticipated Return Of Inflation

inflation courseInflation of consumer goods prices ignores the price inflation of many other goods such as – most notably – assets

Inflation is back. The first stage has been the rise in oil prices from $30 to $50 per barrel, which is already being passed on to the consumer economies. It’s what the central banks have been looking to do for the last eight long years, push up inflation towards the almost universal target of 2%. It wouldn’t be a bad thing if it were a little higher and the banks did not start to restrict the monetary offer just when it reaches 2%. The rise in inflation is a sign of increased demand. For this to continue, it has to be consolidated in inflation expectations. But these expectations have to be moderate if their effect is not to be too destructive. An inflation rate of between 2% and 4% would be optimum.

So why is moderate inflation better than no inflation? For the last eight years, we have been living with almost zero inflation, even deflation, which, logically, was not an incentive for investing or hiring, given the expectations of such low profit margins (prices minus costs). Added to this, “Animal Spirits” ( investors moods) have been very pessimistic. Both of these factors have dampened investor enthusiasm, which has meant that not enough jobs have been created to put an end to unemployment. And that, naturally, has pushed back consumption. But if the inflation rate was the same in all areas of activity, would it not be the same if it’s 0% or 3%?

There is one theory – that of the natural interest rate – which says there is one real interest rate (deflated by inflation) which is the one which pushes the economy to full employment if the markets are sufficiently flexible, because it balances out savings with investment. Let’s suppose this natural rate is 2%. An inflation rate of 4% and an interest rate of 6% achieves this natural rate of 2%. If inflation is negative, for example -2%, the nominal rate has to be 0% in order for the natural rate to be 2%. The more inflation declines, the more difficult it is to reach the so-called natural rate.

We need to add to this the fact that markets are not so flexible, particularly the labour market. Salaries tend to “drag their heels” when there are attempts to push them down, for many reasons. Contracts are signed for a fixed time period. There are salaries which a company prefers to maintain before losing employees who have been trained and are productive. But in reality, there is a lot of uncertainty both for companies and workers over what is the salary which will keep their job. Even without trade unions, salaries are not flexible on the downside. And the lower inflation is, it’s even worse. So there are less hirings and more firings.

A drop in inflation is generated by the fact that everyone, consumers and businessmen, hold on to their money when faced with an event which increases uncertainty. This is money which is taken away from the markets and from demand, so prices decline. In an ideal world, this fall in prices would re-establish (the Pigou effect) the real value of the money which has been kept back – it would increase its purchasing power – which in turn would be an incentive for demand to return, or for money to go back into the markets. But this is very simple: what happens if deflation expectations don’t stop at one particular point? People know that the longer they hold on to their money, the more they can buy if they wait. Why are you going to buy a car if you know that within a year it’s going to cost X% less? It’s as if they were giving you a yield of X% for keeping your money. If this X% is greater than the market rate, you are getting a higher return, and by definition risk-free, than if you bought bonds,

There is not enough certainty that prices are going to fall by a certain amount and then stop. If we knew beforehand where deflation was going to go, the central bank’s job would be easier. The Central Bank wants to replace the money which has been kept back, so that people see it’s not worth as much as they think. If we know that deflation is going to be X% one year, the Central Bank could inject the sufficient amount of money needed to convince people that’s it not going to be so; that demand will soon return. But deflation expectations are difficult to eradicate (look at Japan). There is a coordination problema between the different agents involved, who are not clear on how others are going to behave.

What needs to be done is to re-establish the automatisms in place when things were going well. And for this, a minimum inflation rate is needed. Below this minimum level, companies don’t know what their margin will be, nor employees what their salary will be in a year’s time. The lack of confidence increases, all the more so wjen the fall in prices and salaries is bigger and prolonged.

Too much inflation is a bad thing: it creates rising expectations and people try to anticipate them. Too little is even worse. The 2008 crisis caused a very costly deflation. And now there are signs that inflation is rising. It would be a good thing for the Central Banks not to be too rigid with their inflation targets. That said, the Fed is hiking rates before inflation reaches 2%. As soon as inflation ticks up in Germany, there will rows in the ECB. There is every indication that reaching maximum potential growth will not be allowed. Particularly taking into account the anti-deficit policy which will be unleashed. Once the restrictions on both sides coincide, and that is not handled with care, it will be difficult to maintain the momentum.

 

 

About the Author

Miguel Navascués
Miguel Navascués has worked as an economist at the Bank of Spain for 30 years, and focuses on international and monetary economics. He blogs in Spanish at: http://http://www.miguelnavascues.com/