Inflation: Why Worry?

Central banks first started targeting specific levels of inflation in the early 1990’s. The goal of this move was to consign high (unstable) levels of inflation to the past. In the UK, for example, inflation peaked at 24.89% in 1975, giving any individuals paying variable interest rate mortgages, personal loans etc. a major headache – the same, of course, applied to businesses. In 1974, the rate had been 19.1% and it fell to 15.1% a year later. Uncertainty about borrowing costs can drastically affect the viability of businesses and can plunge homeowners into the dangers of repossession.

The case for low, stable, inflation is easy to understand, but given that in many major economies it is currently below target, why are central banks hoping to encourage it upwards? The answer is twofold. Firstly, in a situation where prices fall (deflation) it is conceivable that consumers will delay purchases, hoping that the goods that they want will be cheaper when they eventually buy them. This situation has been blamed for the lengthy stagnation of the Japanese economy by subduing domestic demand. How likely is it that such a situation could obtain in a Western economy where consumers expect and demand instant gratification and are used to using credit to have things they want now?

The second reason is more elusive and has possibly been overtaken by events since the Global Financial Crisis. The reason given is that nominal interest rates (i.e. central bank interest rates) cannot become negative and consequently a low positive level of inflation must be targeted. Except, of course, some central banks (Switzerland and the ECB spring to mind) are “paying” negative interest on the deposits that they hold for commercial banks. Central banks traditionally use interest rates as a brake or an accelerator on the economy, hiking rates to reduce inflationary pressure and “cool” an economy and conversely, dropping rates to boost economic activity with (so the story goes) a lagging increase on inflation as economic activity takes off.