The inflation paradox

A recent major announcement has been the fall in inflation to 0.5% – a level not seen since May 2000. The UK Government has heralded it as a tax cut in real terms for the UK consumer; but is low inflation actually a good thing?

General consensus amongst economists and governments is that some inflation promotes steady economic growth. In fact the Governor of the Bank of England, Mark Carney, must write to the Chancellor explaining why inflation has missed the UK target of 2%.

Moderate levels of inflation have the effect of stimulating growth via consumer spending – if you knew that expensive car or television was going to fall in price next month would you still buy it today?

But the key drivers of the drop have been falling oil, gas and food prices – all of which are essential purchases for the average consumer and cannot be deferred until next month. A fall in the price of these actually has the effect of increasing our spending power (providing wage inflation exists). So perhaps David Cameron is right to shout from the rooftops; perhaps he’ll keep shouting till May 7.

But there can be other negative consequences.

Certainly the markets reacted with surprise at the announcement, with the pound falling against the dollar. Good for UK exporters, but bad for importers and holidaymakers. What caused this slight devaluation of sterling? In part, an erosion in the expectation interest rates will rise in the near future; they are now likely to remain low for a little while longer.

Intense price competition amongst supermarkets and major department stores has also led to recent announcements of store closures and jobs cuts for both general staff and top directors. Dairy farmers as well have been badly affected of late.

The Government themselves may also be adversely affected as higher inflation tends to erode the cost of holding debt, of which they have rather a lot.

Monetary policy seeks to control inflation levels, usually via interest rates, but when these are already rock bottom what can the Bank of England actually do? Quantitative Easing has been a policy used extensively since 2009 to increase private sector spending by flooding the market with money to lend and spend, resulting in higher inflation. This stimulus has its detractors but is likely to continue as a policy in the future.

All in all, it’s a balancing act. Low inflation appears good in the short-term but is not something the UK economy should seek to maintain for the foreseeable future, so expect some action before too long. The key goal is promoting long-term stability.

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