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Inflation's not the problem

Inflation is not our problem now. It is changes in relative prices, and shifts in real resources, we should worry about
Inflation's not the problem
  • inflation, meaning a rise in the general price level, is only a small problem
  • Our bigger problems are a transfer of real resources from dynamic sectors of the economy towards owners of oil and gas fields, and long-term rises in the costs of services

Inflation is not a big problem. What we should worry about are things that are associated with inflation but are not actually inflation.

Yes, this sounds strange. Inflation erodes the value of money and such is the power of compounding that even moderate inflation devalues money a lot over time. The gilt market is pricing in retail price index (RPI) inflation of 4.3 per cent a year over the next 10 years. Which means that, measured by the RPI, £1 today will be worth only 66p in 2032. Granted, most economists think the RPI is a bad measure of inflation, but the gilt market’s forecast implies that the consumer price index will rise 40 per cent over the next 10 years. That means that if you are spending £2,000 a month now you’ll need to spend £2,800 a month in 10 years’ time to have the same lifestyle.

Sounds scary?

It’s not. Inflation, strictly speaking, is a rise in the overall price level – not just the price of beer, sausages and haircuts but of labour, equities, interest rates and everything else. Inflation, therefore, raises your wealth and income as much as your outgoings. Net, we are no worse off. If we are, it is because relative prices have changed – which is a completely different thing.

But it is this that is our problem now. Higher energy costs shift resources towards owners of gas and oil fields and away from more dynamic sectors of the economy. This, and not inflation, is our problem.

Put it this way. In the 12 months to February petrol prices rose 22.3 per cent and utility bills by 23.1 per cent (with more to come soon). These alone contributed 1.5 percentage points to February’s 6.2 per cent consumer price index (CPI) inflation. But what if prices in the rest of the economy were flat, so that inflation was below its 2 per cent target. Would everything be OK? Obviously not: we’d still be worse off, and oil and gas suppliers better off. Our problem would be much the same.

Allied to this is the fact that wages and welfare benefits are not keeping pace with prices. Average earnings rose just 4.8 per cent in January (the latest month for which we have data), and most welfare benefits will rise by just 3.1 per cent this month, far less than the rate of inflation. Millions of people, then, are worse off. But this is not because of inflation. It is because they lack the economic and political power to protect themselves.

With luck, these problems will be temporary. Futures markets are pricing in lower oil and gas prices next year. Something else, however, is not temporary. Prices do not rise at the same rate over time. Instead, over the long run, the prices of services rise more than the prices of goods. In the past 30 years the prices of services in the CPI basket have risen 169 per cent while the prices of goods other than food and energy have risen less than 20 per cent. This is the result of a real longstanding worldwide fact – that productivity gains are harder to make in services than in goods.

This has two implications. One is that taxes will rise over time, because of the rising relative cost of government services such as healthcare and education. The other is that if you spend more on services than the average person you will face a higher inflation rate than official data show. And there is one particularly important group of such people – those who will need social care later in life.

It is possible to ignore general inflation in our everyday financial planning. What we cannot ignore, though, is the likelihood of changes in relative prices.

This raises the question: if our problems are changes in relative prices and a lack of bargaining power, in what respect is pure inflation – a rise in the price of everything – a problem?

Extremely high inflation, of the sort we saw in the Weimar republic or Zimbabwe or Venezuela, is of course catastrophic, not least because it’s a symptom of terrible government. But nobody thinks we now face hyperinflation.

You might think high inflation is bad because it reduces economic growth. It creates uncertainty, which makes it hard for companies to plan, therefore depressing capital spending. Rising wages drag people into higher tax brackets thus raising their marginal tax rates and so reducing incentives to work. And high and volatile inflation make it difficult to distinguish between absolute and relative price changes, which means the price mechanism no longer works so well in signalling to us what to produce more of and what less.

These mechanisms all sound plausible. This brings us to a surprise. Back in the 1990s, when there were debates about whether central banks should target inflation, economists studied its impact on growth and found – well, not very much. Some found that very high inflation depressed growth, but others found not even this. “Inflation is unrelated to growth,” concluded Ross Levine and Sara Zervos in one typical paper. Subsequent events vindicate them. In the past 20 years, annual inflation (measured by the RPI) has averaged 2.9 per cent, 1.4 percentage points less than in the previous 20 years. But real GDP growth has been much lower, at 1.4 per cent a year compared with 2.7 per cent between 1981 and 2001. And growth has also been a full percentage point lower than it was between 1961 and 1981 when annual inflation averaged 9.2 per cent. Of course, countless things affect longer-term growth, but these numbers show that inflation is not a powerful influence upon it.

Instead, there are other costs of inflation. When it is high, and when interest rates are high, we want to minimize how much cash we carry and how much we have in current accounts rather than in better-paying savings accounts. Doing this, however, is a hassle. Economists used to speak of shoe-leather costs, the time wasted walking to the bank, but today the hassle consists of remembering passwords and getting onto banks’ websites. Even in the 1990s, however, economists estimated these costs to be small – and in a world of contactless payments, they are probably even smaller.

Inflation, then, is not actually our problem. Talk of it distracts us from much nastier issues, such as shifts in real resources towards sclerotic sectors and despotic governments; a lack of political and economic power, which is plunging people into real poverty; and a long-term rise in the relative price of some necessary services.