April 25, 2008 | posted by Michael Baxter in inflation |

You could be forgiven for concluding the government and regulators are caught between a rock and a hard place.     Inflation is back, right? It could even rise to more than a full percentage point over the Bank of England’s target this summer, enforcing another of those embarrassing letters from its governor to the chancellor.   This would suggest interest rates need to go up.     At the same time the arguments for a cut in rates are obvious and, frankly, further cuts seem inevitable.

So, on the one hand, the economy desperately needs lower rates to counteract the effect of the credit crunch. On the other hand, it needs higher rates to stop inflation in its tracks.  It has been heralded by some as a choice between 1970s-type inflation or 1930s-type depression.    What a dilemma.

It’s just that it isn’t like that at all, as data from IRS on wage inflation released yesterday shows.

It all boils down to the difference between inflation and price rises.

Prices go up if demand is greater than supply.   Inflation is a sustained rise in prices, caused not so much because demand is greater than supply, but because the dampening effect of higher prices is cancelled out by something else, creating a situation in which demand is permanently higher than supply.  

So oil goes up, wheat goes up, and then rice goes up in price.     The key to determining whether we have inflation is what happens next.   Even then, even if inflation seems to occur, we still don’t know whether the answer is higher interest rates until we examine the causes of this secondary effect of rising prices.

There are three possible scenarios, only one means higher interest rates. 

Scenario one: Commodities have been going up in price because of pressure on supply.    Higher prices should reduce demand until equilibrium is restored – prices then become flat.  Inflation has not occurred.  We are all a little worse off. This is how it should be. If there isn’t enough food or oil to go round then we should all lose out. If we don’t, something is wrong with the price mechanism. 

Scenario two: Prices continue to rise because of supply or external factors.    So, if we have had a run of bad luck, successive bad harvests, for example, constraining supply, prices will rise, but it has nothing to do with domestic demand pressures.   Prices go up, and we are worse off – and again it should be that, we can not be immune to paying the costs of bad harvests.   Alternatively, demand might be rising in other countries – this might mean demand is too high on a global scale but British consumers themselves are not putting prices under pressure. This is not a reason for higher domestic interest rates.

But scenario three is more serious.     As prices rise, we enjoy higher wages. We are not worse off.  There is no magic in economics. If prices rise because products are costing more, then we are either worse off, or deluding ourselves.  This is when inflation becomes a problem.  This is when inflation becomes a form of delusion – and once it sets in, it is difficult to stop it.

The good news came yesterday, because IRS revealed that the median rise in wages agreed by wage negotiators in the first quarter was just 3.5 per cent – below rises in the retail price index. 

Of course, current demands by teachers for above-inflation wage rises might be justified from a moral point of view, but the view that wages need to rise to keep up with price rises is just bad economics.

Normally, one would expect inflationary wages during a time of lax monetary policy.  Excess money creates the lubricant for inflation-busting pay rises.       If there is too much money floating around the system, an upward self-supporting spiral of rising prices can be created.

A credit crunch must presumably mean less money in circulation.  That’s why cuts in interest rates can be justified, and why they won’t necessarily be inflationary.

But have no doubt that higher commodity prices will hurt us – either in the form of less disposable income,  or in the form of higher inflation – leading to higher interest rates.  

There is nothing central banks can do about that.