So what if inflation rises? The answer is both obscure and obvious.
To see the problem, remember that inflation strictly speaking is a rise in the general price level – of wages and prices. That means that it raises both your outgoings and your income leaving you no worse or better off. Of course, high inflation in practice has been accompanied by relative price and wage changes and so has produced winners and losers. But so too has low inflation. Such changes in relative prices are not inherent costs of inflation.
So why is higher inflation a bad thing? To get a perspective here, we should go back to 1997 when the Bank of England was making the case for targeting inflation. Its economists then showed how inflation was indeed a bad thing even when everybody can see it coming.
This is not, they found, because higher inflation reduced economic growth. Sure, very high inflation does so, but there was no evidence then or now that inflation of around 5 per cent is worse for activity in the long-run than inflation of around 2 per cent.
Instead, they said, inflation has other costs. For one thing, it is bad for savers. We get taxed on our nominal interest income. Which means that when interest rates are (say) 6 per cent and inflation 4 per cent we pay more tax than when rates are 2 per cent and inflation zero, even though real pre-tax interest rates are the same. This means we must either save more, or face a poorer future.
Similarly, high inflation quickly erodes the spending power of cash and zero-interest bank accounts, encouraging us to tie up our money in higher-interest accounts. But this means we must go to more bother to move money between accounts when we need the cash. Economists used to call these “shoeleather costs” because we had to walk to the bank more. These days, the costs are trying to remember a gazillion passwords on their damned websites, which isn’t an obvious improvement.
And then there’s the fact that if prices are rising rapidly, firms incur administrative costs in changing prices more often.
Effects such as these are real. Bank economists calculated that they were equivalent to 0.2 per cent of GDP per year for every two percentage points of higher average inflation.
This is worth having, but it isn’t much.
So why are so many people so bothered by inflation? It’s because while a steady-state of moderately high inflation and interest rates is no big deal, there are big costs in moving to it. Higher inflation means – eventually – higher interest rates. And rising interest rates are a threat to asset prices – especially bonds and house prices: the price of any asset is the net present value of the future benefits of owning it, and higher rates increase the discount rate applied to those benefits.
Investors, I suspect, aren’t much bothered by inflation. What really scares them is the prospect of rising interest rates – not least because after years of zero rates this is an unfamiliar prospect: hardly any investor under the age of 35 has any professional experience of significantly rising rates. They might be right to be scared – or at least, to be scared that other people might be scared.
