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Do we really want to try and keep inflation at 2%?

By Andy Shaw | January 23, 2010

Originally Posted 12th July 2007

This is opening up a can of worms :-)

You know this obsession the government and therefore we ourselves have about trying to keep inflation at 2%. Well I’ve been wondering for some time now, and a lot more recently as to whether we really want to try and keep inflation at 2%?

When I think about inflation I hear the voice of my Mum telling me of the terrible times in the early seventies when the price of a loaf of bread was going up each time she went shopping. I also saw on the news yesterday about how bad the hyper inflation in Zimbabwe is working out for them.

On a side note I had relatives who were white farmers there. They are now living in Australia and when I first went out with Alison back in the late eighties I predicted that one day they would be kicked off their land and the government would collapse under hyper inflation. Well the prediction has nearly come completely true, watch this space.

Then I think about the hyper inflation that happened in Germany after the First World War and I must admit the thought of too much inflation does worry me, especially if you have someone who is too cavalier at the helm.

However, I also think that having someone who is too set on keeping a definite course when it is obvious that a correction is needed is also very scary. I take it we all remember when the government tried to keep the value of the pound in the right area and raised interest rates several percent in a day. That’s not several 0.25% rate rises like we have seen in the last year, that’s 3 times as much as we’ve had in the last year in ONE DAY!

I remember Margaret Thatcher saying that you can’t buck the markets, and she was right. And I think what is going on now is an attempt to control something too harshly to the detriment of the economy as a whole. I know even bringing up this topic for discussion is really going against the grain, but then that’s me really. The trouble I have is I think the government is trying to buck the markets and keep inflation at 2% when it should be allowed to grow a little.

I agree that we do not want to see too higher inflation, and I am not saying that I’m enough of an expert to give an accurate statement of what the correct level of inflation should be. But I think it should be an open subject rather than closed off the way the government seems to want it. And because nobody fully understands the subject (including me :-) ) nobody is really even questioning this policy, it is just considered a given that very low inflation is the correct path. And even if I didn’t understand the effects of inflation the way I do then the very fact that everyone believes in something is enough of a reason for me to question it, as I believe when opinion is in the majority regarding this sort of thing then the chances are it is probably wrong.

First off, what is the real rate of inflation, because if you take all factors into consideration including house prices then you’ll almost certainly find that inflation is a lot higher anyway, and I’m just guessing here but probably around 6%. So is this just the government trying to disguise the underlying rate of inflation or are they just inept.

Let’s just say that the true average inflation rate wants to be 7%, and the government has entered a period in history when the rates are well below this level and likely to remain that way for several years for example say the year 2000, because as with all markets the market swings high and low. So now let’s say when we were in one of those low rate swings we decided to set inflation at 2%. We made political headlines out of it and as my bank manager would say, we hung our hat on it, in other words it’s a fixed policy. Now lets say that because on normal market progress in other areas, such as business growing at more than 2% a year and property rising at more than 2% a year for several years then the underlying rate would be well out of whack with current policy. Then this would mean all of a sudden we were working to keep the economy artificially low. Is this a good thing?

I’m not sold on it, or rather as far as I’m concerned the jury is still out!

Furthermore the Bank of England will continue to raise rates in an effort to fight the increase of inflation. Well how much are they prepared to buck the markets, a 3% rise in a day perhaps? Maybe they are prepared to do that again? For reference on a £100,000 mortgage that would be a monthly increase of £250, or a better way of putting it, would be rates going from 8% to 11% (Why 8% well they wont be doing a quick rise from where they are now, will they? Things will have gotten worse K). So if they do not change this policy then we could once again see double digit interest rates. Nasty!

The problem is that the government is trying to keep things down, yet it is considered the norm for a 5% wage increase now in most businesses. And in the city 5% it would seem that this sort of increase would be chump change. So why are we trying to keep something at too low a level when a more acceptable rate would help the country to grow further?

In the US the long term house price to earnings ratio is 2.6 times and currently it is at 3.4 times depending on what source you go to. Off the top of my head I don’t know the UK figures. I hear the economists saying that house prices cannot continue to go up as people cannot afford to buy any longer because this ratio is out of whack (I don’t think the economists use the term ‘whack’ though!).

The problem is that is it right to hold back wage rises when the country wants to expand, is it more likely that the government needs to hold back wage rises because of the growing army of civil servants and the potential ‘knee in the nads’ a 5% wage rise annually could do for the governments budget. The problem is that are they fighting the just cause of low inflation for the right reasons, or are they fighting it because they need to keep under control a mess that they are not capable of clearing up.

My conclusion is I think that what will happen is the government will see sense and see that they can’t fight inflation without damaging the economy too much and as such will raise their expected inflation rates to around 3% for next year.

The trouble is that I think this is too little and they need to relax it a little more and let the market breath. They can easily bring in the constraints by raising interest rates harshly if the economy starts to move too quickly. As this will cause us all to suck it in pretty quickly!

When I learned to fly I was taught the value of being flexible on my course, and if I did that then I would have a far greater chance of reaching my destination, basically that meant flying around the storms. My opinion is that if the government carries on heading in their current direction then I think a tidal wave will capsize them as they are not even prepared to head into the wave!

Best Wishes


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