Is Low Inflation Desirable and Sustainable?

Is low inflation desirable and sustainable?

Introduction

In business, financial and political circles, inflation is one of the most commonly discussed economic subjects, with arguments regarding the optimum levels appropriate for national and international economies. From the research available, it would appear that the majority of experts, including banking executives, agree that low inflation provides the preferred economic environment (Griffiths and Wall, 2004). The intention of this paper is to ascertain the validity of this position and whether, if it is proven that low inflation is desired, it can be sustained. In order to reach a conclusion, it is necessary to first provide and understanding of the term inflation itself; methods by which low inflation targets is achieved and examine the benefits of maintaining the position. Inflation In general, when the word “inflation” is mentioned most people consider that it refers to rising prices. In fact, price rises are the result, rather than the cause of inflation (Dan Blatt 2004), and generally, once they reach a certain level, are deflationary. Inflation is caused by a number of other factors or inflationary forces.

These forces include changes in monetary policy, which occur when a government expands the money supply. Such an event might happen when they are seeking to encourage more spending by consumers. Monetary inflation is an artificial way of creating an upward moving economy by increasing the amount of money available for consumers to spend, for example, when a country is endeavoring to recover from a recession or, in the case of third world countries, developing their economies (Professor Otmar Issinbg, 2003). The problem with monetary inflation is that it has the effect of increasing demand, irrespective of the level of supply. As demand continues to outstrip supply, prices will rise, this will create an inflationary situation based on price, where such increases are used to try to restrict the growth in demand to match the supply levels (Griffiths and Wall, 2004). In the past, these two opposing forces have caused economic rollercoaster periods for the UK economy, as witnessed during the “strato-inflation with double-digit inflation rates” of the 1970’s (Brittan, Samuel, 2002), which then dropped back sharply in the early 1980’s. This “boom and bust” boom effect continued until the early 2000’s (see appendix 1).

Erratic swings in the inflation rate have an adverse effect upon confidence in a country and its currency. In times of high inflation, that confidence weakens, and the currency value falls, which can lead to a country being forced to devalue its currency. The problem with this position is that it adds fuel to the inflationary forces, pushing up cost of goods being imported. (Griffiths and Wall, 2004). Achieving optimum Low rates of Inflation Whilst inflation itself may not be a bad thing, because it helps the growth of an economy, this only works within certain narrow parameters. Faced with the crippling swings of inflationary situations indicated previously, and the effect these had on the nations consumers and currency internationally, the majority of economists came to opinion that the most productive way forward for national and global economies, was to aim for a position of low inflation. It can be seen that, since 2000, the UK the rate of inflation has succeeded in achieving a more stable inflation rate at lower levels than had been experienced in the three preceding decades (see appendix 1).

To achieve low inflation, it is necessary to create an economic environment that encourages capital investment, a achievable and sustainable growth rate; a position in which the nation’s currency does not come under threat from the international community, and that does not damage consumer confidence (Griffiths and Wall. 2004). To do this means that there must be a less divergent position existing between demand and supply. The closer these two economic elements are, the lower will be the economic inclination towards price inflation, and the more stable that economy becomes. If a nation’s economy does not perform as erratically as the UK’s did in the 1970’s, the global financial markets will not lose confidence in the currency, and this will assist in the lowering of the inflation rate. Historically the UK’s economic strategy has been determined and managed by its political leaders. Before this century, the UK government’s economic power had included controlling the interest rate levels and monetary supply system. Subsequently and as part of the aim to achieve low inflation, the government relinquished these two powers and changed their monetary policy. As Gordon Brown (editorial, 2002) explained, “under the new monetary and fiscal system based on the independence of the Bank of England: we [the UK government][1] imposed an inflation target that is symmetrical, designed to combat both deflation and inflation.” This position allowed interest rates to react more closely to indexes and changed to reflect these, preventing inflation’s predetermined corridors from being breached.

From the UK’s economic performance over the past five years, it can be seen that a position of low inflation rates has been more easily achieved because of this policy of less political involvement and interference (Griffiths and Wall, 2004). Most of the western world has adopted this position of indexation, outside of direct governmental control, contributing to the achievement of low inflation (Brian O’Reilly, 1998). However, it is also necessary to understand that there is limit to the level that inflation rates should be allowed to fall. In some ways, allowing inflation rates to drift too low is almost as bad as allowing high inflation. Zero or extremely low levels of inflation can damage the economy. As has been found in Japan (Samuel Brittan, 2002), low rates of inflation are often accompanied by low or nil levels of interest rates. If adverse conditions affect an economy in this position, a problem is created in terms of the country’s ability to react. It would not be possible for the financial institutions to lower interest rates, as this would move them towards a negative position. The political and economic leaders would be virtually powerless to react. Therefore, as Gordon Brown has done (Samuel Brittan, 2002), it is just as important for the government’s economic policy to have a lower minimum limit target for inflation as it is for it to have an upper limit. Benefits of Low Inflation We have seen that low inflation is achievable, but for that achievement to mean anything, it has to produce benefits. In the case of low inflation, the first of these benefits would be the eradication of the risks of uncertainty by the achievement of “economic stability” (Harley and Davies 2001).

As the Bank of England report (Mervyn King, 2004) explains, in a situation of low inflation, consumers, suppliers and the government all benefit. For the consumer, the cost of borrowing will be lower, and the purchasing power of their money will not be as drastically reduced as happens in periods of high inflation. This will increase their confidence and feeling of security. For the supplier, whilst it is not proven that low inflation leads to higher growth, equally, as Walter Stanners (1993) concludes, is does not “disadvantage” growth. As with consumers, low inflation assists the corporation by reducing the growth in their costs. In addition, to the extent that low inflation benefits the consumer, it can be said that for the commercial organization low inflation will reduce their financial risk. For example, this situation would be particularly true for financial and property institutions (Harley and Davies, 2001). In periods of extremely high levels of inflation, the consumer defaulting levels on loans and other financial arrangements had an adverse effect on such industries. Low inflation reduces the risks in these areas. Therefore commercial organizations, whether in the product of service industries, are likely to achieve greater levels of profitability in times of lower inflation, than at other stages of the economic cycle. The political benefits of low inflation are an equally important factor. Whilst high levels of inflation put pressure on the national economy and currency, often forcing the government to reduce its reserves to increase confidence, low inflation does not have this effect. As a result, the nation as a whole remains competitive in the global marketplace. Similarly, it helps to maintain and control the cost and value of imports and exports by not providing overseas trading to gain a cost advantageous cost-benefit, which in itself could fuel inflation. Sustainability Having achieved low inflation rates and gained the benefits from this position, one then has to look at whether any country, the UK is included, can sustain the required inflation levels. Sustainability of low inflation would rely upon a number of situations. For example, were the UK economy able to operate in an independent and isolated manner the difficulties would probably not cause a problem. However, with increasing globalization, this is not an option.

There are international factors that could pose a threat to the sustaining of the inflation level. For example, if the market's confidence in the currency of another country ceases to exist, that countries currency becomes cheaper against the UK currency. The knock-on effect of this is that it would influence the UK’s ability to sell to that country by making UK goods more expensive (Anatole Kaletsky, 2006). Eventually, this could lead to oversupply. To address this situation, it is important there be put in place a level of international cooperation on inflation levels, such as has begun to surface with the introduction of the single European currency (the Euro). Similarly, the international market needs to continue to work towards a position of free trade as barriers to trade can, as Gordon Brown (Anon, 2002) has already appreciated, put pressure on the national inflation rates. It is for this reason that most countries are working towards the removal or modification of existing trade agreements. Inflation rate sustainability can also be affected by issues that are outside of normal commercial practice. For example, if one looks at the after-effects of incidences like 9/11 in America and 7/7 in the UK, for a period of time these did affect the inflation levels of the countries involved.

Conclusion

The conclusion drawn from our research is that low inflation rates are beneficial, from both the national economic aspect and the confidence with which other nations view the country that is operating within these inflation limits, and from the fact that, as has been seen, it is beneficial to all of the stakeholders within that nation. It therefore follows that low inflation is the desired economic route that individual nations should seek to achieve. As to whether the position of low inflation can be sustained over a specific number of years, this is a matter of some conjecture. There are a number of imponderables. Activity from external sources over which low inflation countries have no control could easily jeopardise the inflation rate. This is why the seeking of international cooperation by way of global trade agreements is such a vital ingredient in providing economic stability in the international community. Such sustainability must also be viewed against the potential impact of terrorism or war. References Griffiths, Alan and Wall Stuart (2004). Applied Economics. Financial Times/Prentice Hall. London, UK. Harley, Ed and Davies, Stephen (2001). Low inflation. Implications for the FSA. Financial Services Authority. London. UK. King Mervyn (2004). Low Inflation and Business. Bank of England. London, UK. O’Reilly, Brian (1998). The Benefits of Low Inflation. Bank of Canada. Canada. Stanners, Walter (1993). Is Low Inflation an important condition for high growth? Cambridge Journal of Economics. Vol. 17, 1993. pp. 79-107 Editorial (2002). Full text: Brown’s speech to the CBI. The Guardian. UK. Issinbg, Prof. Otmar (2003). Considerations on monetary policy strategies for accession countries. National Bank of Hungary. Hungary. Brittan, Samuel (2002). Inflation can be too low. Financial Times, UK Kaletsky, Anatole. (2006) The deflation threat facing Europe. The Times 20 November 2006. UK Blatt, Dan (2004) Understanding inflation. Recovered 7 December 2006 from https://www.futurecasts.com/Understanding%20Inflation.html Appendix 1 Figure 1 Inflation graph UK

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Footnotes

[1] Words in brackets added.

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