Air conditioning is useless when it is cold: Why zero inflation is not "good news".

George Osborne tweeted recently that zero inflation is "good news". Prices not rising can only be good thing surely? But if zero inflation is so good then why is the target rate of inflation set at 2% inflation, why not 0%? And also, didn't George Osborne recently reconfirm the inflation target of 2% in his budget? 

In short, zero inflation is not "good news". George Osborne is hoodwinking you and making you look like a chump.

Although there are some great bloggers in the UK discussing this issue (see Tony Yates and Simon Wren Lewis), their blogs may be a bit advanced for those who have not suffered through an economics course. This blog is for the man/woman on the street, a person who doesn't know economic jargon but cares about what is happening to the economy. So with this in mind, let's start with some basics...

What is Inflation and why is it bad?

Inflation is the average rise in prices within an economy. If a pint costs £5 and inflation is 100%, the price of a pint of beer is likely to rise with inflation and now costs £10 (I teach university students who for some reason seem to have a good grasp on the price of beer). If your wages stay the same then it is a bit like getting your wages cut in half! In a similar way, inflation is also bad for savers as if you have £50 in your bank account you can now only buy 5 pints instead of 10. On the other side, inflation can be good for people with debt, it is analogous to paying less back than you borrowed. Most importantly, understanding inflation ruins your Grandparent's stories of going to the pub with a penny and leaving with 2 thrupney bits.

So this means deflation is good right?

Deflation is the opposite of inflation - it is the average fall in prices. If a pint costs £5 and inflation is minus 50, your £50 in your bank account can now buy you 20 pints! This seems brilliant right? Well this is what George Osborne and a lot of the media have been saying. But it does beg the question if deflation is so good why not set the target rate of inflation to minus 2% rather than the current 2%?

The first reason is to do with wages. If your wage stays the same then deflation will be good for you. But it is likely that firms will want to start cutting your wages if prices start to fall. If you have wage cuts of 2% and prices fall by 2% then nothing has really changed for you. This is why you should try and get a wage rise at least in line with inflation or you will be worse off than you were last year! 

In reality, people really don’t like having their wages cut. I think people would generally prefer a wage rise to prices falling, but this is possibly down to individuals not understanding economic phenomena. Economists call this "downward wage rigidity", or in other words, “what the hell is deflation - get your hands off my wages?!”

You may say that deflation is better for savers, as prices are falling the money in my bank account can buy more stuff. If I am borrowing money, however, it means I will have to pay relatively more back. But again, this all depends on what interest rate you are getting on your savings.

To really understand why the current situation of 0% inflation is bad, however, we must first describe what is behind these average changes in prices.

What causes inflation and deflation?

Inflation can be caused by either (or a combination of) too much demand in an economy or too little supply. Deflation occurs for the opposite reasons: too little demand in an economy or too much supply. This is probably best explained with an example of someone who makes and sells cakes for a living.

Let’s say you go to market to sell your cakes. You have a steady flow of customers but then people start getting really hungry and you have a massive queue for your cakes. You may think about charging as much as you can get away with and raise your price for your cakes to make more profit.

But what if the next day you go to the shop to buy ingredients for your cake but you find that the flour has doubled in price. As this raises your costs it reduces the amount of cakes you can make (hence supply decreases) and so you may have to increase your price. Now if this is happening to a lot of business throughout the economy we will see the average price rise and hence inflation. This analogy can be reversed to describe how deflation works.

One of the reasons why we are experiencing zero inflation at the moment is due to an increase in supply due to oil prices falling (think of flour becoming cheaper in the previous example). As a lot of products use oil (from oil comes petrol – think transport costs falling), this will mean companies can cut prices (they may not want to cut their price but if a competitor does in order to capture the market they will have to follow).

So what is the problem? Well, our cake seller is having a hard enough time setting their price to deal with their own changes in demand and supply so having to deal with average price changes - that are nothing to do with the quality of the cakes or the way the cakes are advertised - is really annoying! We really need someone to sort out all these average price changes in an economy so that cake makers throughout the land can predict these movements in average prices. Cue, the Bank of England...

What does the Bank of England do?

The Bank of England tries to control inflation by affecting interest rates. Their objective is to hit a certain target of inflation. Imagine the Bank of England is like air conditioning and the target rate of inflation is that sweet spot - not too hot and not too cold. If it is too hot (inflation is above target and prices are rising too fast) you turn the air condition on full blast to cool the economy. This would be equivalent to increasing interest rates – saving becomes increasingly more attractive to borrowing, so people spend less and prices fall. If, however, it starts becoming cooler (and inflation is looking like it is falling below target) we start turning down the air conditioning. This is equivalent to cutting interest rates and borrowing becomes more attractive. This tempts people to spend more and makes prices rise. Changing the interest rate in this way is what economists call monetary policy but for our purposes we can think of it as air conditioning.

Why is 2% the “perfect temperature” and why not 0% if inflation is so bad?

What really matters is that there is a target inflation rate and the Bank of England can consistently meet that “sweet spot” temperature. The perfect temperature can be subjective, but what we can all agree on is that it shouldn't change a lot and it is predictable - you don’t want to be having to put additional layers on and taking them off all the time! You want the temperature nice and constant. This is just like having an inflation target, we want a constant level of inflation so it becomes easy for us to predict what inflation will be (or what we are going to wear).

One of the main reasons why 2% is the target rate of inflation is that it becomes easier to keep the temperature nice and constant. If we set it at 0% (which is what Andrew Sentance would like) we may end up in the situation where we have switched the air conditioner off but it is still getting colder. In other words, interest rates are zero and they can’t get any lower. The worse case scenario is that we end up in a deflationary spiral. If prices start to decrease, wages decrease. This will then cause prices to decrease as people have less money to spend and the process starts over again spiraling down.

What makes this notion of a 0% inflation target an even worse idea is that interest rates are already near zero now and prices are falling. This is a bit of a problem because even with a 2% target our air conditioner is off and it is getting pretty cold. This situation is described by a rather abstract sounding economic term called the zero lower bound (ZLB). I think we need to rename it to something like “air conditioning when it is freezing (LOL)”.

Can we not just turn the central heating on?

As the air conditioning of the economy (interest rate changes) is ineffective when it is freezing outside, we may want to think about turning the central heating on. The central heating in this case is government spending. This can be in the form of tax cuts or building new hospitals and schools in an economy. This essentially creates more demand in the economy (if you get a tax cut you may start spending some of that money, building a new hospital creates jobs and new businesses will pop up in the area).

But are we not in massive debt? The government says that we cannot afford to spend any more as the debt is so high! This argument seems to have become the accepted view in the UK despite it being untrue - much to the dismay of myself and most other economists. Paul Krugman sums it up pretty well. Basically, the US is more informed than the UK...

Although this will take another blog to explain, the simple answer is that debt is a long term problem and this freezing temperature is short term. We should turn on the central heating (government spending) while it is cold and when we get back to normal temperatures we can start using air conditioning again (interest rates). Once temperatures are normal again we can start repaying the debt. Also, if prices do end up falling, this will make the debt harder to pay back anyway. If you can't wait for my next blog then you should read this and this.

Can we change the “sweet spot” temperature?

In the longer term it could be the case that changing the “sweet spot” temperature to a slightly higher temperature may be a better idea. This is so we can ensure air conditioning never becomes ineffective. This is what Tony Yates argues and advises that the inflation target should be increased to 4%. 

But wait, didn't we decide the “sweet spot" target is an inflation rate of 2%? Well, as I described earlier, the “sweet spot” temperature is one that doesn't change much and is predictable. If it is a little warmer I can just take a layer off but at least I know I won’t have to keep putting stuff on and off again! This doesn't mean that Tony loves inflation, I am pretty sure he would be just as annoyed if inflation was 2% under or 2% over the target rate. 

Jeremy Warner thought this was a ludicrous idea suggesting that raising the target will just raise inflation and as inflation is bad, raising the target would be a bad idea. However, this misses the point entirely, it would take a long time to implement this new target. It is not a short term solution to current freezing temperatures (unlike government spending).

One of the main reasons why the Bank of England controls air conditioning (interest rates) is that their sole purpose is to hit the “sweet spot” temperature by hitting the inflation target. 

Basically, if the Bank of England cannot guarantee that they will be able to hit that “sweet spot” temperature, we will stop believing them when they say that this particular inflation target is what they are trying to achieve. If this starts happening, and the Bank of England loses credibility, then our air conditioning unit will become faulty and it will take a long time to repair.

Is there any other way we warm the place up a bit?

We could warm up the place by creating demand with quantitative easing (I never like the phrase quantitative easing, it sounds like a laxative marketed towards accountants). It is fairly complicated to understand the inner workings of it, and not essential to this post, but it is basically creating money to increase demand within an economy.

I may have stretched my analogy a bit far but let us say that quantitative easing is like starting a fire in the house. Sure it may get you warm, and if controlled properly it unlikely to set the whole house on fire (despite some peoples worries). However, quantitative easing isn't a tried and tested method; it is very difficult to know how much the temperature will rise when starting a fire compared to central heating (government spending) or air conditioning (monetary policy). 

In a nutshell

If we think of the Bank of England controlling inflation like an air conditioner, then current conditions means that it is so cold out the air conditioning is switched off and it is getting colder. We need to increase the temperature by increasing demand. Personally, I think turning the central heating on by increasing government spending is the best option until we can get to a temperature where air conditioning can be used again. For a long term solution increasing the “sweet spot” temperature by increasing the target rate of inflation might be a good idea so we can always use air conditioning. This is because turning the central heating on always causes arguments... just like increasing government spending.