Now, you might be surprised by this. To those of us saving for retirement, higher inflation, when combined with low interest rates, means we’ll lose money not just on our cash savings but also quite possibly on shares too. To compensate for low returns, we might choose to save more. Insofar as we do, this would depress demand.
So, how can Simon be right? There are three possible reasons:
- If people expect prices to rise, they might bring their spending forward. “Spend your money now, while it's still worth something!" says Nick Rowe of Carleton University in Ottawa.
- Yes, savers suffer lower incomes which might make them want to save more. But there’s also a substitution effect; if expected returns on savings are low, we might not bother to save, and spend instead.
- Inflation erodes the real value of debt. People with negative net financial assets can therefore anticipate a rise in their net wealth if they expect inflation to rise. And if people feel they’ll become wealthier they should spend more now. Remember that, in aggregate, UK households have more debt than bank deposits.
Recent history suggests that these expansionary effects of higher inflation expectations can offset the contractionary effect. To see what I mean, let’s look at households’ inflation expectations. Since 1999 the Bank of England and NOP have asked people every three months: “How much would you expect prices in the shops generally to change over the next 12 months?” In their last survey in May, the median answer was 3.6 per cent.
If we look at annual changes in this median answer, we see that it is strongly negatively correlated with changes in the households’ savings ratio; the correlation is minus 0.53 since 1999, which is quite impressive considering the volatility of the two series. In other words, when inflation expectations rise the savings ratio falls - which implies that consumer demand rises for a given income. For example, in the year to Q3 2008, inflation expectations rose 1.7 percentage points and the savings ratio fell by 0.9 percentage points. In the year to Q2 2009, inflation expectations fell by 1.9 points and the savings ratio rose 5.9 percentage points. In the year to Q1 2011 inflation expectations rose 1.5 percentage points and the savings ratio fell 2.1 points. And in the year to Q3 2012 inflation expectations fell by one point and the savings ratio rose 0.7 points.
Of course, this is just a univariate correlation, and many other things affect the savings ratio. But the raw data is consistent with Simon’s point – that a rise in inflation expectations can raise aggregate demand, by making us more likely to spend than to save.
There are, though, two problems here. First, if inflation expectations do rise and demand picks up as a result, it’ll be despite policy and not because of it. In setting out the Bank’s remit, George Osborne wrote in March: “The inflation target of 2 per cent applies at all times…The inflation target is forward-looking to ensure inflation expectations are firmly anchored in the medium term.” But any rise in inflation expectations would mean they are not “firmly anchored”, and that policy has failed, by its own standards.
Secondly, whilst a fall in the savings ratio would give a short-term boost to aggregate demand, it’s not a viable long-term option. In the longer-term the savings ratio might have to be quite high, so that households can repair their over-leveraged balance sheets and prepare for retirement. In this sense, the best hope for the economy is the prayer of the youthful Augustine of Hippo: “Give me chastity and continence, but not yet.”
