Tuesday, 8 December 2009

Why low inflation is better than no inflation.

1. Low inflation is helpful to economic growth. See previous blog.

2. Maintaining a zero inflation monetary policy can lead to unpredictability and instability in the economy. An inflation targeting policy like the SARB´s 3 to 6 percent target range seeks to maintain a constant rate of inflation. Unfortunately inflation always moves to the top of the target range, thus doubling the cost of inflation in SA´s case. At continuous 3% annual inflation only R60 billion per annum will be destroyed in the real value of the Rand and SA accountants will only unknowingly destroy about R100 billion in the real value of existing constant items (e.g. reported Retained Profits) in the SA real economy with their very destructive stable measuring unit assumption instead of double these values as currently happens. Adherence to a constant low rate allows firms to make reasonable predictions in the future about price and wage levels, but, it causes structural or built-in inflation in the economy. A zero inflation policy would attempt to correct for past deviations. A past period of inflation would have to be corrected by a period of deflation. Past deviations cannot be let go as zero inflation (a set price level) has to be maintained. This need to correct past deviations means that the monetary authority might have to take drastic action to swing the economy in the other direction and so actually increase unpredictability and instability in the economy rather than decrease it.

3. Zero inflation increases the risk of the economy slipping into deflation. The decrease in prices causes nominal wages to fall while their real values increase and fewer goods to be produced, which in turn causes prices to fall further causing further decreases in nominal wages but increases in real wages under the current Historical Cost Paradigm. Production and employment normally decrease too. A low rate of inflation provides a safety barrier against this. Deflation is also very hard for a monetary authority to correct. See Japan’s “ten lost years”. Interest rates typically cannot be used at a negative rate.

4. Downwards stickiness in prices and wages. Wages in particular are very hard to negotiate downwards as workers and trade unions are naturally very reluctant to accept nominal cuts in wages in an inflationary environment. However, if downward adjustments were not possible the disequilibrium in the economy would cause instability and a decrease in economic growth. A low inflation rate allows real wage decreases, while avoiding nominal cuts simply by having no wage increase or a wage increase rate lower than that of inflation. It is in this sense that inflation has been called the grease on the wheels of the economy.

5. Avoiding a possible liquidity trap. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the central bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy.This is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate. Some economists assert that even under an occurrence of a liquidity trap, expansive monetary policy could still stimulate the economy via the direct effects of increased money stocks on aggregate demand. This was essentially the hope of both the Bank of Japan in the 1990s, when it embarked upon quantitative easing and of the central banks of the United States and Europe in 2008-9, with their foray into quantitative easing. All these policy initiatives are attempts to stimulate the economy through methods other than the mere reduction of short-term interest rates.

6. The real interest rate is normally still positive at low levels of inflation; thus, inflation provides a savings and investment incentive as it is preferential to save or invest than just have your money on deposit at no return thus losing real value at the rate of inflation.

Kindest regards,

Nicolaas Smith