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The price of inflation

Governments would like some inflation to bring down the levels of their debt but it is difficult to control

Jonathan Cornell
Jonathan Cornell

Ever since the bank rate reached its record low of 0.5 per cent last year we have all been debating when it is going to rise. Last year, it looked like there would be an increase in the first half of the year but that has not happened.

Each Bank of England monetary policy committee meeting seems to be a foregone conclusion that the bank rate will be kept on hold as the economic recovery is too fragile to risk an increase.

Writing press releases for bank rate announcements has never been easier as you only need to write one and you can do it well in advance.

However, with the latest set of figures showing that in May that the Government’s chosen inflation measure the consumer price index standing at 3.4 per cent, down from 3.7 per cent in April and the retail price index, widely used in pay talks, fell to 5.1 per cent in May from 5.4 per cent.
The slight fall strengthens the Bank of England’s argument that inflation will head down significantly in coming months. If this is the case, then the bank rate may remain on hold into 2011.

The austerity measures launched in the emergency Budget should also help bring inflation down as increases in taxation would reduce disposable income.

The MPC will need to tread a careful path. It is battling to bring inflation back to 2 per cent, which is the target figure, but it does not want to overshoot and bring inflation below 2 per cent (or even worse lower than that) as it is desperate to avoid the deflation that has blighted the Japanese economy for the last two decades. Deflation is where prices fall. This has the cataclysmic effect of pushing buyers to delay any major purchases as they know these items will get cheaper.

This procrastination has a negative impact on purchasing, meaning that GDP falls, which has a terrible impact on the overall economy.
Other major economies are working hard to avoid deflation as well. Privately, however, I think most of the major governments would like inflation to increase.

All government debt in the form of gilts is on an interest only basis and typically at a fixed rate, so an increase in inflation would erode the real value of the debt without affecting the payments.

Since most governments now have record levels of debt, any way of reducing this would be very welcome and, on the face of it, seems easier than reducing expenditure or increasing taxation.

The problem though is that inflation is a bit like toothpaste, once it is out of the tube it is very difficult to get back in.

Most of the major economies battled through the late 1980s and early 1990s trying to get inflation back under control.
For most people, high levels of inflation would be a bad thing as the MPC would be forced to increase the bank rate and as most borrowers are not on fixed rates, mortgage costs would soar.

Few, if any, borrowers could cope with their mortgage payments if the bank rate went above 10 per cent. Some would struggle even if it goes as high as 5 per cent, which is pretty much the long-term average over the past decade or so.

Jonathan Cornell is head of communications at First Action Finance

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