Monday, 28 February 2011

Inflation & What to do about it.

There is no doubt that the cost of living is rising fast. Oil, Food and Money (interest rates) are all getting, or about to get a lot more expensive. However as I said on Friday moring to those unfortunate enough to be both up at 5:30am and listening to Radio 5-live, the Libyan crisis and the wider revolutions in the Middle East are not the underlying reason for Oil to be at $100, nor are Chinese crop failures or poor harvests in the USA the underlying reason for agricultural commodities to be going through the roof.

When there is inflation in the system - prices going up - the orthodox response is to raise the cost of money, reduce the amount of money in the system by making it harder for people to borrow, spend and invest. This has the effect of slowing economic activity, and so, conversely, when the economy slows, you reduce rates to get the economy moving. However, the effectiveness of raising rates in reducing inflation is limited when almost all the inflation comes from things like import prices for oil and foodstuffs, and one-off increases in tax, and almost all effectiveness it has there is due to higher interest rates strengthening a currency.

So if we raise rates to strenghthen the currency, what happens to the export-led growth we're told is necessary to get the economy moving in the face of a weak consumer in the UK?

The real reason for the rise in commodites is the flip side of interest rates. In the UK it should surprise no-one that reducing interest rates increases the price of property. This is because the supply of property cannot be raised quickly, and if you increase the volume of money chasing a resourse with short-term inflexible supply, it should be no surprise when the price goes up.

The same is true of wheat and oil in a way it is not true of manufactured goods whose supply can be rapidly raised. So why do media commentators persist in putting geopolitical reasons behind the oil price, and pointing to droughts and local harvest failures for agricultural commodites (when there are such events somewhere every year) when the real culprit is simple. Quantitative easing across the developed world - the USA, Japan and the UK have all indulged - increased the supply of money, and because no-one wanted, or could get a mortgage on property, it inflated the prices of other assets: first financial assets such as bonds, then shares. This went as far as the market thought prudent, meanwhile it also started to feed into commodities. More money chasing a fixed (in the short-term) supply of oil and wheat. Very little of the debased new currency went into "stimulating" business, and instead, it lined the pockets of petro-dictators.

Interest rates in the UK have to rise, but apart from currency effects, this will have little effect on inflation, and may yet stimulate increased wage demands. Raising interest rates too soon risks stagflation. Too late risks runaway inflation and asset price bubbles (if we're not already there). I suspect therefore that Interest rates will start to rise a bit later than May and caution will be the watch-word.

In the mean time, short-term substitution effects of Libya's unusually light, sweet (low-sulphur) crude aside, there is an idea that widely expressed idea that oil is marching ever upwards (eg raedwald who has summed up the opinions of an average well-read non-expert). I am not so sure. There is no physical shortage of Oil. The same arguments got their airing in 2008, and the price subsequently dropped back. I am convinced the monetary effects, once they are through the system will lead to drops in the price, and I am equally sure that everyone will be putting this down to "new democratic stability in the middle-east".

If interest rates rise too much, then under such a scenario, the UK then looks like flirting with deflation as falling commodity prices and a strong Pound mean everything starts to look cheap.

On such things are economic cycles made. People ascribing the wrong cause and effect, and getting the controls wrong. When they're right, it's probably for the wrong reason. Most of the time, they're not too bad and the market interest rate is not set by the bank, but by Libor. Perhaps it's time to get rid of the anacronism of a Bank of England base rate altogether, and just set everything off Libor, which has decoupled from Base in recent years? Let the market decide how much money they need. The MPC, independent though it is meant to be, is still too statist. Setting interest rates has been described as attempting to drive a truck down a road at night with a blacked-out windscreed, only using the rear-view mirror. Oh and the back window's cracked. No-one can have enough information to set an interest rate, so why try?

So the correct answer to what to do about inflation is 'Nothing'. Governments shouldn't even be doing what they're doing now by attempting to control the money supply (this argues for "free banking", a subject for another post). Leave well alone. This lesson is applicable to anything governments do. Even where governments MIGHT be able to help, the chances are they'd make a mess, so the precautionary principle and all available evidence everywhere points to Austrian School economics and Political Libertarianism. However governments don't like to be told "nothing, in fact stop what you were doing before" when asking "what should we do?" So politically it's a non-starter.

Small-state libertarians therefore suffer the fate of Cassandra: we're right, but no-one believes us.


Barnacle Bill said...

It amazes me how few of our so called experts have failed to realize it is Ben Bernanke with his almost non-stop printing of greenbacks that is the root cause of much of our present inflation.

Weekend Yachtsman said...

Last year - money-printing; this year - inflation.

You'd think even politicians would be able to work out the connection, wouldn't you?

Perhaps we really are doomed to repeat the 70's for every new generation for ever; or at least, for as long as we've got paper money.

stevehem said...

It wouldn't be too bad if central bank governors mechanically applied a formula to determine the bank rate. The obvious one is the Taylor Rule, although I think that targetting nominal GDP wouldn't be a bad idea (say, keeping it growing at 3%). Unfortunately the current process just results in the MPC responding to political pressures to 'just do something' much as in the system before BoE independence.

I'm looking forward to your post about Free Banking. This surely is the way forward, given that the current fractional reserve banking has utterly failed to reduce the incidence of systematic financial crises despite having been tried for the best part of a hundred years.

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