November 14, 2013 4:36 pm
Inflation is an unpleasant side effect, not the cure
It makes no sense to aim deliberately for a high rate to create jobs
Sometimes the person in the street is wiser than the policy intelectual. After decades worrying about too much inflation some of the would-be intellectual policy commentators are now worrying about too little. But the UK consumer is hardly likely to complain that the consumer price index is “only” 2.2 per cent higher than a year ago and has hardly ever been as low as the official target of 2 per cent.
The latest scare arises because the inflation rate in the eurozone has fallen to a year-on-year 0.7 per cent or an “underlying” 0.8 per cent. The surprise cut in the European Central Bank official short-term interest rate was entirely justified – indeed belated – as an attempt to boost real output in the euro area, which has been falling or stagnant for more than two years. Any upward impact on the euro inflation rate will be a cost and not a benefit.
The ordinary shopper is not likely to riot because prices are not rising faster. Some commentators worry because they associate low inflation with stagnation and high unemployment. Presumably they associate high inflation with prosperity. In that case they should explain why Latin American countries that often experienced double-digit inflation in the 20th century are not role models today.
Too rapid or unexpected a drop in inflation is indeed likely to cause dislocation, but that is an entirely different concept to a low but fairly stable inflation rate.
I can still remember Eugene Black, a former head of the World Bank, saying a little bit of inflation was like a little bit of pregnancy – it grows. The parallel was not strictly accurate. The tools exist for holding inflation around any given rate.
But the very political temptations that cause political authorities to tolerate a modest rate of inflation also entice them to go one higher, and so on and so on.
The most famous attempt to justify moderate inflation was made after the second world war by Bill Phillips, a New Zealand engineer turned economist. He drew up a curve, based on empirical data, showing an inverse relation between unemployment and wage inflation. Lower unemployment is associated with higher inflation.
The trouble with that curve is that it assumed “money illusion”. This meant that it presumed wage bargainers took no notice of inflation in their bargaining. The illusion could not persist in the long run, in which we are now very much living. The end result of a prolonged debate was to suggest that there was just one range of unemployment consistent with any stable rate of inflation and that attempts to improve on it had to concentrate on the structural features of the economy.
The new Bank of England inflation report predicts a one-step increase in the recovery rate of real gross domestic product over the net few months accompanied by a further slight decline in the UK consumer price inflation rate. It does not worry that inflation will be “too low”. This does not mean that the Phillips curve slopes the other way. The BoE hopes that a “gradual revival in productivity growth and a persistent margin of spare capacity should contain domestic price pressures, ensuring that inflation is close to target in the medium term, despite a continued contribution from administered and regulated prices”.
The projections of the normally more radical National Institute of Economic and Social Research point very much in the same direction. The best assumption to make about the Phillips Curve is that it is vertical in the long term and its shape in the short to medium term depends on conjunctural factors and policy changes about which it is impossible to generalise.
The practical upshot of all this is that it makes no sense to aim deliberately for a high inflation rate to create Jobs. If attempts to boost the economy lead to a higher inflation rate, this is an unwanted side effect. A military offensive is likely to involve casualties, but these are unwanted side effects, not the object of the operation. Any upward impact on inflation from economic growth is an unfortunate side effect, not the object of the operation. One cannot blame practical policy makers for looking at transitional effects of this kind as a quick indication of how policy is working, but that is not their real objective.
Can you imagine military commanders worrying that there are not enough casualties? If they can achieve their objectives at a lower cost in lives this should be thoroughly good news. In the privacy of their tents they might express surprise at having achieved so much at surprisingly low cost; and they might legitimately examine whether they have achieved as much as the headlines suggest. But any hint that they should deliberately aim for more deaths and wounded would lead to their swift dispatch.
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