FT Comment: Are we ruined or are we in clover?

17th June, 2006

It is so small a thing: the core consumer price index in the US rose 0.3 per cent in May instead of 0.2 per cent. Yet the news was enough to send the bond markets into a spin and rekindle the topic of the day, the return of inflation.

The markets are not, in fact, worried about the return of inflation at all. They are worried about how far central bankers the world over are likely to raise interest rates in their determination to stamp it out. It is not the disease but the cure that investors fear.

You might be forgiven for wondering whether we might spare ourselves the cure after all. What is wrong with 0.3 per cent monthly inflation? Indeed, what is wrong with much higher inflation? If inflation at 20 or 25 per cent a year really did return to the US or the UK, it is hard to pin down exactly what the problem would be for the man in the street.

The obvious answer is that life would get expensive: say hello to the GBP10 ($18) pint of beer or the GBP1m car. The obvious answer is wrong. In a world of 20 per cent inflation, salaries would also be rising. When you are earning GBP5,000 a week, the GBP10 pint leaves cirrhosis well within your reach.

The true problem is obscured by my reference to “the man in the street”. The average person would hardly be affected at all. His wages would rise, interest payments on his savings would rise and, while he might hesitate to keep too much cash under the mattress, this would be a modest inconvenience.

The people who would really notice a bout of inflation would be those who are not typical. Anyone with a flexible-rate mortgage would suddenly find themselves forced to pay money back early: their mortgage payments would go through the roof while the value of the debt they owed would quickly disappear. That is no disaster, but if they had wanted to overpay they would already have done so. Meanwhile,anyone with a long-term fixed-rate mortgage would be in heaven; anyonewho had bought long-term bonds would be in hell.

Inflation redistributes. Unexpected, high inflation moves wealth around so violently and capriciously that it destroys it. The real victims are often pensioners, reliant on the accurate measurement of inflation, and the poor, who are unlikely to have access to inflation-proof assets.

Pensioners should be protected against inflation because the value of their pensions is typically linked to the rate of inflation. Unfortunately, that protection depends on whether the measured rate of inflation really reflects their cost of living. Most pensioners would not be happy tobe told that while heating costsand property taxes are up, the pension will not rise because theprice of computers and adventure holidays has fallen to compensate.

Relative prices rise and fall all the time in a healthy market economy and those price movements will always create winners and losers. But high inflation makes the relative price movements harder to fathom, harder to compensate for and probably much larger.

It is a measure of inflation’s whimsy that nobody really knows whether inflation is worse for the poor or for the rich. Much depends on the intricacies of the tax system: what corporate profits truly are after inflation; how much tax people pay on interest payments that look generous but in fact are just compensating for the melting away of their savings accounts; whether tax thresholds are adjusted in line with inflation. But an important World Bank research project led by William Easterly and Stanley Fischer, who is himself now a central banker, showed that inflation hits the poor hardest and is also feared most by the poor.

Of course, if inflation really takes off, people will no longer know if they are rich or poor, or what goods are really worth any more.People trade cigarettes and coffee in hyperinflationary times, not asobjects of barter but as alternative currencies. Money is supposed totell you how much things cost and if the dollar and the pound and theeuro no longer fulfil that function, a pack of Lucky Strikes will have to do.

Erich Maria Remarque’s novel, The Black Obelisk, describes life in theGerman hyperinflation of the 1920s. After lighting a cigar with a 10mark bill, the narrator, Ludwig, turns to his friend Georg. “How arewe doing really? Are we ruined or in clover?” Georg replies: “I don’tbelieve anyone in Germany knows that about himself.”

But I am getting carried away. Ben Bernanke is not calling in every dollar in circulation so that the Federal Reserve can stamp some extra zeroes on them. We will not see a return to hyperinflation, nor even, most probably, to more modest inflation of 10 or 15 per cent. The central banks know that chaos can easily grow from small beginnings,as people clamour for higher wages, spend money as soon as they receive it and refuse to lend except at vast interest rates. Maintaining moderate inflation is a little like trying to stay moderately pregnant. Let the central bankers give us their medicine, even if the taste is likely to be bitter.

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