The return of inflation?

2021-03-02 at 12:40 Timo Löyttyniemi

Inflation has not made a comeback, but it has resurfaced as a subject of debate. There are several reasons for this. One is nostalgia, because many fear an overall fall in prices. Another reason is the heavy debt burden of states and a lot of consumers who wish that inflation would eat into the real value of debts.

The United States shows the way

The US Federal Reserve relaxed its inflation target in August 2020. An increase in inflation would be fine with the FED, which would not tighten the monetary policy even if the inflation rate exceeded 2 per cent. The important thing would be to keep average inflation around 2 per cent over business cycles.

Many are prepared to go even further, calling for intense state-driven stimulation through large-scale borrowing. At the same time, others favour a gamble in which brakes won’t be applied until inflation starts galloping.

Will ageing create inflation?

The acclaimed economist Charles Goodhart and his co-author speculated recently that inflation will make a comeback. They argue that ageing – which used to hold inflation in check – will inevitably begin to have the opposite effect. There will be a shortage of labour. A wage-price spiral would create inflation.

Deflation will fail to materialise

Many fear deflation. But it is not something to be worried about. After all, it will be addressed by central banks one way or another. Deflation – or the threat of deflation – can be averted by pressing the inflation button. However, problems may potentially arise if this button is pressed repeatedly: the fear of deflation may easily lead to hyperinflation.

Greener on the other side of the fence

Now that inflation is low, many people wish it was higher. If we imagine a world in which inflation is rampant, we can easily visualise the problems it would cause. In the 1980s, I took part in an inflation seminar in Iceland. At that time, inflation was galloping in the country at an annual rate of 40 per cent, causing a myriad of problems. Many of us remember the 1970s energy crisis and the subsequent austerity measures that helped contain the rampant inflation.

Illusory dynamics

When prices increase, it creates an illusion of growth in the economy. Wages go up and a lot of other things change and develop. Everything appears a little more dynamic compared to a situation in which wages and prices remain tediously unchanged. However, what ultimately matters in an inflationary environment is real economic development.

An intrinsic feature of inflation is that it must always be held in check. If not, it explodes out of control leading to problems of a much larger scale. Normally, the biggest problem with higher inflation is that the central bank is compelled to fight it by increasing interest rates. The economy needs to be curbed, or it drifts into a state of relative weakness, in order to regain a new equilibrium. As far as real earnings are concerned, such strong medicine is not welcome. A steady improvement is probably preferable to intense fluctuations and accompanying deceleration.

Address the true problem

Wise people have concluded that there is no point in fixing a non-existing problem. If the economy grows (even if slowly), the interest rates are low and inflation slow, is this not a situation that many people dream of? Yet this has been the reality for a long time. Maybe so much so that we have reached a saturation point that many people would like to get past.

If we now succeeded in creating inflation, interest rates would increase. But inflation would hardly generate any real growth. We would end up with low real growth and high interest rates, plus a host of other problems brought by inflation. In the United States, every post-war inflation has been suppressed by raising interest rates, which has led to weaker real growth.

The true problem both in Europe and Japan is the challenge presented by demography and the deteriorating dependency ratio due to ageing. There is a strong tendency to make every effort to maintain moderate growth. Far too often, these efforts bypass the actual problem. This has led to a heavy debt burden that will only increase in the coming years. And it is not a question of responding to business cycles; unfortunately, it is a more long-term problem.

A change in thinking

It is difficult to change the overall circumstances overnight. The challenges posed by the ageing population, the shrinking workforce and diminishing flows of income and consumption due to demography are limiting growth opportunities in Europe. Borrowing helps stimulate the economy to bridge gaps in the business cycle. However, the age-induced shortfall will be with us for at least the next 20–30 years. Probably the biggest challenge in this period will be debt sizing.

One option is to get used to the current situation in which inflation, rarely enough, is not a problem. Growth, inflation and interest rates are all low. In Japan, this situation has persisted for almost 30 years. And they are facing the same demographic problems as we are in Europe.

In conclusion

Usually, inflation is perceived as a problem. And now that we have none, even its absence causes concern. Grass is believed to be greener on the other side of the fence. It is only natural that people strive for the better, and rightly so. But it should be noted that the current situation is not all that bad, considering the age structure of the population.

The writer is VER's CEO Timo Löyttyniemi.

TLö blogi 2020

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