Unit 4 Macro: Dangers of High Inflation

The annual rate of inflation in the UK has overshot its 2 per cent target in 51 of the past 60 months and this has led some economists to believe that the Bank of England has been adopting a tacit policy of allowing inflation to stay above target by keeping official monetary policy interest rates at 0.5% since the Spring of 2009. The Governor of the Bank of England Mervyn King has expressed his concern about “uncomfortably high rates of inflation” but the Bank’s Monetary Policy Committee has yet to reverse the steep falls in interest rates that came in the wake of the global financial crisis in 2008-09.

Although modest but persistently higher inflation might be helpful in reducing the real value of outstanding government debt there are also underlying dangers in allowing above-target inflation for a considerable length of time. This blog will look at these.

Income redistribution: One important risk of higher inflation is that it has a regressive effect on lower-income families and older people in society. According to figures produced by Alliance Trust in June 2011, rising inflation in Britain is hitting the elderly hardest because prices for food and domestic utilities such as water and heating have been increasing at more than 5 per cent a year. This was before the announcement of another 15-18 per cent hike in electricity and gas prices announced by the major utility businesses in the summer of 2011.

Many households are effectively on fixed incomes, and when prices rise, they can afford to buy less and less. Soaring energy costs has driven hundreds of thousands of vulnerable people into fuel poverty - a situation where more than 10 per cent of family income drains away in meeting fuel bills.

Further evidence for the impact of high inflation on poor people in Britain has come from new research from the Institute of Fiscal Studies (IFS). They found that between the years 2008-10, the poorest fifth of households (the 1st quintile) faced a rate of inflation of 4.3% pa in contrast to annual price rises of 2.7% for the richest fifth of households. The inflation rate for pensioner households dependent on state benefits was 4.6% pa whereas richer families have benefitted from lower mortgage costs and continued deflation in the prices of many leisure goods such as televisions, mobile phones and computers.

Falling real incomes: With millions of people facing either a cut in their wages or at best a pay freeze, rising inflation leads to a steep fall in real incomes and is a key factor behind a squeeze in consumer spending on goods and services. With consumption accounting for over 60 per cent of aggregate demand, a fall in household spending risks dragging the UK closer to a double-dip recession and this will eventually hit government tax revenues from VAT, excise duties and corporation tax on business profits.

Negative real interest rates: If interest rates on many types of savings accounts are lower than inflation - and with many savings accounts today, they are - then they too fall behind rising prices, and people who rely on interest from their savings will also feel poorer. Real interest rates for millions of savers have been negative for at least three years and the situation shows little sign of improving in the near-term. This hits the incentive to save and may mean that UK banks have less deposits flowing into their accounts as a basis for lending out to those who need to borrow.

The cost of borrowing: High inflation may also lead to higher interest rates for businesses and people needing loans and mortgages as financial markets seek to protect themselves against rising prices and increase the cost of borrowing on short and longer-term debt. The government also faces having to pay more interest on their existing borrowing since many bonds were issued as “index-linked” securities where the rate of interest tracks the annual rate of inflation. There is also pressure on the government to increase the value of the state pension and unemployment benefits and other welfare payments as the cost of living climbs higher.

Risks of wage inflation: Much of the recent increase in consumer prices in Britain has been due to the soaring cost of commodities in international markets - foodstuffs, oil and gas and many globally-traded minerals have all seen sizeable price rises hitting the pockets of hard-pressed consumers and raising input costs for businesses across many industries.

Because the economy has barely come out of a deep recession in 2009, there has been little appetite for workers to bid for inflation-protecting pay rises especially when unemployment is high and job insecurity is rife - but this might change if inflation stays high through 2011.

Inflation expectations have been rising and the hit on real incomes is something that millions of people are experiencing at the moment. It may turn out that inflation of 4-5% (well above the 2% target) might actually be quite damaging for prospects of a sustainable economic recovery.

Here is a super video from Declan Curry on the winners and losers from a period of higher inflation