Inflation is like cholesterol, it’s not all bad

Insights, Perspectives 2021
9/15/2021 by Dan Scott Reading time: 2 minute(s)
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Inflation, especially the out-of-control type recently witnessed in countries like Zimbabwe, has been described as a scourge of humanity. A salary worth dramatically less day-to-day is indeed the recipe for economic decline and even revolution. Europe, haunted by wartime memories of hyperinflation, may be particularly sensitive to signs of rising prices. However, just like cholesterol, there is a bad kind and a good kind of inflation.

A modest amount of inflation is healthy. It reflects a solid growth of the economy, corporate earnings, or employee wages. We need this kind of inflation just like we need high-density lipoprotein, the “good” cholesterol that cleanses our blood.

Since the global financial crisis, central banks have been desperately trying to stoke inflation – without success. A moderate rise in prices of up to around 4 percent or 5 percent on the previous year’s level in an economic upswing gives monetary authorities the option of cutting rates in a subsequent recession. However, the countercurrent deflationary trends tied to digitalization, ageing populations, and globalization, have time and again proved stronger than central banks’ efforts.

Until recently, double-digit inflation rates in industrial countries appeared to be a phenomenon of the past. Such levels were reached during war times between 1800 and the Second World War, and again during “oil price shocks” in the 1970s. This caused central banks to rethink their approach to monetary policy. Now that we see spikes in inflation here and there, is this finally the consequence of the large central banks’ extraordinary steps?

Paying less for debt in the future

The upward pressure on headline inflation we have seen in the past few months is mainly still due to base effects, seasonal patterns, and some difficulties to increase the production capacity of otherwise well-greased economic engines. But even if this proved to be more than a blip on the inflation screen, it wouldn’t be much of a worry if the rise remained under control. After all, inflation can be a scourge but, when remaining moderate, also a sign of vigorous economic activity. Moreover, a controlled inflation rate can help bring government debt down. It can be easier to settle a debt of, say, 1 billion US dollars in an inflationary environment because inflation lowers the price tag over time.

We should fear deflation, not inflation

We shouldn’t forget that the opposite of inflation, deflation, can be far more devastating. There is no good version of this phenomenon. During periods of a broad downward move in prices, consumers have no incentive to spend. Companies respond by cutting costs and laying off workers, thus starting a toxic downward cycle. Deflationary trends have proven notoriously hard to break. Japan, the world’s third-largest economy, has been using all means available to fight deflation and trying to prop up prices for years. This so-called Japanification of the global economy is what central banks and governments in the West have been trying to avoid. The liquidity flood they have unleashed on our global economic system must ultimately bring about at least a moderate degree of inflation. If it succeeds, we could witness a repeat of the last century’s roaring twenties. If not, we may need to brace for a Japanese-style lost decade.

 

  

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