Today it was announced that the CPI measure of inflation had fallen to 1%, a 12 tear low and also well below the Bank of England’s 2% target. Lib Dem dogsbody Danny Alexander welcomed the news, saying “This is a welcome early Christmas present to millions of families across the country.” Thanks Santa! The thinking in Government seems to be the lower the better, because they are desperate to negate Labour’s ‘cost of living crisis’ attack, but is low inflation really a good thing? Helpfully, FT columnist Tim Harford wrote a short piece on this in February, some of which I will reproduce here:
“What wrong with low inflation?
Nothing, so far – but you can have too much of a good thing. Inflation is also low and edging downwards in the US, Japan and the eurozone. Yet in all these places, interest rates are low and central bankers have printed enough money to get the tinfoil hat brigade screaming about hyperinflation. Such low inflation might be an indication of trouble ahead.
Are you saying that low inflation is a bad thing, or are you saying that low inflation is merely a harbinger of doom?
A bit of both – but mostly I am concerned that low inflation is a bad thing in itself. One issue is that unexpectedly low inflation redistributes from borrowers to creditors.
About time too, most savers will be thinking.
I hear you. Still, borrowers are more likely to be cash-constrained (that’s why they are borrowers) and are more at risk of bankruptcy. That means lower-than-expected inflation may damage the economy as a whole rather than just moving money from one person’s pocket to another’s. And there’s another problem with deflation: the “lower-bound” problem.
It’s a fancy way of saying that nominal interest rates can’t fall below zero. If inflation is, say, 4 per cent then a central bank can give an economy a shot of adrenalin by cutting interest rates after inflation to minus 3 or minus 4 per cent. If inflation is 0.7 per cent – as it’s currently estimated to be in the eurozone – then that’s impossible.
Why would anyone want real interest rates of minus 4 per cent?
Usually we wouldn’t. But, against the backdrop of a slack economy, such rates would be a strong incentive to spend. And if outright deflation took hold, effective interest rates would rise: people would earn money simply by sitting on their cash and waiting for prices to fall. Sounds great but for an economy it’s a disaster. If nobody buys anything there will be a recession and more deflation – a vicious spiral.
But that isn’t going to happen. Is it?
Don’t ask me, I’m an economist. We never know what’s going to happen to the economy. But it is a serious enough problem that even a low risk is worth losing sleep over.”
I guess the key points are that low inflation harms borrowers in that it raises the real interest rate on existing debt, and if it continues to fall and we get into deflation territory, consumers start postponing spending, believing prices will fall further in the future. This could push us back into recession. So much as the likes of Danny Alexander may celebrate falling inflation, let’s hope it’s not a precursor to some pretty nasty economic problems to come.