Duncan’s Economic Blog

The Politics of Inflation

Posted in Uncategorized by duncanseconomicblog on May 6, 2009

Martin Wolf has, as ever, a interesting article in today’s FT on the failure of inflation targeting and the need for central bankers to do more about asset price bubbles. Worth a read and I broadly agree with his analysis.

The rationale behind the idea of an independent central bank targeting inflation was that, by virtue of not being politically controlled, an independent CB could take ‘uncomfortable’ decisions to control inflation that would have been harder for a government to take. I.e. a independent CB is more likely to raise interest rates (and raise unemployment) to control inflation. As long as the independent CB was seen as credible than the market would realise that it aimed to control inflation and so take this into account when setting prices and wages, in other words it becomes self reinforcing.

Now this notion is open to challenge. I mean, seriously, the argument boils down to democratically elected politicians can’t be trusted to run the economy. I know many who agree with that statement, I personally do not.

Economists, and increasingly politicians, are now debating the future role of the BOE in terms of controlling asset prices. This is to be welcomed, although personally I don’t think the debate is going far enough. The BOE could be a useful part of any future industrial strategy, lending direct to business that we wish to encourage.

The merits, or otherwise, of having an independent central bank targeting inflation can be debated at length but this can all seem a bit academic and distant.

A more immediately relevant debate is what we mean by ‘inflation’. RPI (which includes mortgage interest payments) is currently negative whilst CPI (which does not) is currently still above the government’s target. So, which is correct? How much are prices currently rising?

The answer is: ‘depends upon how much you earn’. PWC did some good research on this issue last summer, actually looking at inflation rates as broken down by what different income groups actually spend their cash on.

The results, for anyone on the left, make for grim reading. The inflation rate faced by the bottom two deciles of earners (the lowest 20%) has been consistently higher than that faced by the highest two deciles. All things being equal this is, a usually unmeasured and forgotten about, increase in inequality.

Whilst inflation was still rising last Summer, the increase was being driven mainly by rising fuel and food costs. As the lowest decline spend more of their income on these items they faced an inflation rate of 5.7%, against a published CPI figure of 4.7% and top earners only 4.6%.

How should the BOE have responded? Hiking interest rates (which thankfully they did not do, although some MPC members voted to) would have been the standard response. And what would this have achieved? Yes inflation would have fallen but at what cost in jobs? And which people’s jobs?

Any debate which treats inflation as one simple number, relevant to all, is likely to miss these vitally important inequalites. And in any debate on the future of central banking they need to be at the fore.

7 Responses

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  1. […] Read the rest of this great post here […]

  2. Bella said, on May 7, 2009 at 7:48 am

    The question is, Duncan, will the government think about the inequalities in inflation across income groups when setting the rate of the national minimum wage for the coming year? Announcement on 11 May, and I think we should brace for abandonment of the progressive uprating policy that has been such a feature…

    • duncanseconomicblog said, on May 7, 2009 at 11:50 am

      Bella,

      I fear you might be correct.

      I hope not.

  3. CharliemcMenamin said, on May 7, 2009 at 10:31 am

    Fascinating. The only justification for an independent Central Bank is that it ‘sticks to its knitting’ and fulfills one main objective. Giving it a licence to pursue wider social or economic aims inevitably means it becomes more and more embroiled in political decisions and, as an un-elected body, I would say that is completely inappropriate if not downright undemocratic and authoritarian.

    Inflation targeting is the usual ‘knitting'(although it is possible to imagine some theoretical Central Bank somewhere being charged with ,say, maintaining employment rates). But your elegant example shows how even this is directly related to politicalclass issues. So where is the case for Central Bank independence left after this demonstration? It just doesn’t stand up at all….

    • duncanseconomicblog said, on May 7, 2009 at 11:52 am

      Charlie,

      Agreed.

      The problem with CB independence was that it presented the ‘battle to control ibflation’ as an entirely ‘economic’ matter best handled by technocrats.

      We are now probably bound in, it would be hard to withdraw the independence without seriously damaging the UK govt’s credibility.

  4. crossland said, on May 7, 2009 at 12:51 pm

    I remember Chris dillow at stumbling & mumbling arguing along the lines that the ‘magic’ effect of central bank independance might have worn off after a few years.
    That it was a novelty effect , once the markets got what they wanted they eventually adjusted back.

    Duncan ,your point about pulling that independance away is very apt – markets may not be as impressed by Bank independance as they were initially but they would probably be unimpressed with it being taken away.

  5. […] Whilst inflation was still rising last Summer, the increase was being driven mainly by rising fuel and food costs. As the lowest decline spend more of their income on these items they faced an inflation rate of 5.7%, against a published CPI figure of 4.7% and top earners only 4.6%. Duncan, Duncan’s Economic Blog. […]


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