When people talk about ‘inflation’, they implicitly mean one of two types: price inflation or wage inflation. So how can we define inflation? In simple terms, price inflation is an increase in the cost of the things people buy, such as food, furniture, fuel and so on. Wage inflation is what happens when salaries go up across the board, regardless of the type of market sector or level of job.
One type of inflation can lead into the other, with higher prices leading to demands for higher wages to compensate, then strikes, capitulation, an increase in prices to cover higher payroll costs, and around again, in what’s termed a wage-price spiral, a type of positive feedback loop.
Measuring the inflation rate
There are various indices that measure price inflation. The UK government used to target RPI (the Retail Prices Index), aiming to keep it below 2.5%: at the time of writing it’s a whisker over 4%. But in more recent times the target has been CPI (the Consumer Prices Index), also known as the Cheap Plastic Index or Chinese Products Index by cynics, because it excludes housing costs and places quite a high emphasis on consumer electronics. Some people complain that ‘real’ price inflation is anywhere between 5% and 10%, depending on who you are and what you buy: you can check your own at www.statistics.gov.uk/pic/
What causes inflation?
Once it takes hold, inflation can be very difficult to stop, with interest rates having to rise much higher than they would in a stable, non-inflationary economy.
Price inflation is particularly problematic in an economy where the trade balance is negative; i.e. an economy that imports more than it exports - like the UK. Inflation is a consequence of a devalued pound relative to other currencies, so imported goods and services priced in dollars and euros, for example, become more expensive in pound terms.
If those imports are generally trivial luxury items, like consumer electronics and other gadgets, there might not be too much of a problem, as people are likely to simply cut back on these: they aren’t called luxury items for nothing.
However, when it’s the essentials that are being imported - food, water, energy, etc. - then inflation is much harder to tackle. Cutting back on such staples is difficult to do, so what tends to happen is that people continue to buy them, but their disposable income goes down as a result and so they cut back on other things. This slows the economy still further and can lead to what is known as ’stagflation’: a stagnant or contracting economy coupled with price inflation.
Arguably the last major inflationary episode in the UK was in the 1970s. Back then we had wage inflation as well as price inflation. Those people with savings saw the real value of their money go down (bank account interest rates rarely keep up with inflation, for good reason: the banks make more money that way).
Those with large debts, such as mortgages, on the other hand, saw the value of their debts decrease relative to their earnings, which is why people who lived through that era are so keen to encourage their children to ‘get on the property ladder at any cost.’ However, there was also the small matter of doubled-digit interest payments, so inflation was only good for mortgage-holders if they could afford the monthly payments. Many could not, and had their homes repossessed.
The effects of inflation
So much for the background, now what about today? Well, the Bank of England is cutting rates even though inflation (as measured by CPI) is above its target. The members of its Monetary Policy Committee have admitted that we are likely to see inflation going up over the coming months, but they think that the cuts are necessary to avoid a recession.
It’s a big gamble. If price inflation takes off, there is less scope for wage inflation this time around. Britain must compete with other countries, many of them keen and hungry for business, and pricing ourselves out of the global market with excessively high wages is not a good idea. This is one reason why the government has been so strict about pay rises for public sector workers recently.
And, since much of our national debt must be paid in euros, dollars and other foreign currencies, inflation won’t help us pay off our debts through devaluation of the pound, unless - and this is possible - the other major currencies devalue too.
The most likely outcome, if inflation does take hold, is that price inflation will be much higher than wage inflation. In other words, we’ll all feel poorer, as our pounds effectively become worth less than they were, but we continue to earn roughly the same amount of them.
Protecting yourself against inflation
There are ways to protect yourself against price inflation. If you have savings, make sure you put them somewhere that pays at least the RPI measure of inflation, after tax. One place that seems pretty good is the government’s index linked savings certificates scheme, from NS&I. This currently pays RPI plus a bit more, and is tax-free.
You could also buy assets that are likely to hold their true value in the face of inflation. Commodities and precious metals have traditionally done this, which is one reason why the prices of wheat and gold have risen considerably in sterling terms over the past year.
Or you could buy a house, if you believe that it will hold its true value relative to wages. However, taking on a big mortgage would be risky, for the reasons described above.
If you have debts, in fact, your best bet might be to pay off as much as you can, while you can. If price inflation surges ahead of wage inflation, as seems likely over the coming year, you may find it increasingly difficult to keep up with the payments on your loans.
And the Bank of England might, at some point, be forced to raise interest rates to protect the value of sterling and prevent further price inflation. The last thing you’d want to be holding in that situation is a large debt.
Inflation can be avoided, or at least mitigated, by sensible fiscal policy during years of growth. That, however, depends on politicians and central bankers looking years or even decades ahead when making their economic decisions. Unfortunately, few understand the underlying economics, and even fewer are willing to take the flak of short-term pain for long-term gain.
(c) Alex Cruickshank 2008
The author believes that Mervyn King will be writing a few more letters to the Chancellor this year.
