Monday, June 3, 2013

Why will inflation be important for economic growth?

The European Central Bank (ECB) has stated its formula for its inflation target on many occasions. At the press conferences that follow the Monetary Policy Committee meeting  every month it is repeated like a mantra: Inflation should be "close to, but not above, two percent per annum".

Inflation means rising prices, and rising prices mean wage demands or, in their absence, as is the case at present because of austerity across Europe, a slow down in real consumption and a further tendency towards recessionary pressure. So why is any inflation at all, even to the amount of 2% per annum, a good thing?

Well, one reason is that inflation is extremely difficult to control precisely, and negative inflation is a real problem because it destroys the market for large asset purchases, such as property (who is going to buy a house this year if they are invited to believe that it will be worth less next year). This means that attempting to aim for zero inflation is unrealistic.

Another reason for a positive inflation target lies in what seems to be happening in the USA at present. There is much noise about the ending of Quantitative Easing, or the pumping of money into the economy in order to stimulate it. Many people feel that QE is a strange thing to have, and is even a little bit dodgy. The problem for the US authorities, however, is that they had already used up all the ammunition in their interest rate locker, by bringing those rates down effectively to zero. Negative interest rates are not possible, so the only thing left is stimulus by effectively printing money.

As inflation and official interest rates are closely linked an inflation rate close to, but not above two percent leaves all central banks with a buffer zone in which they will be able to adjust interest rates in order to stimulate the economy. None of them likes to have to resort to Quantitative Easing, especially the Europeans.

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