Mervyn King is wrong: Inflation isn’t a problem - yet

Inflation shouldn't be our biggest concern at the moment

Writing in the Financial Times, Mervyn King has echoed many economists in warning about the likelihood of inflation becoming problematic imminently. As a former Governor of the Bank of England, if anyone’s warnings should be taken seriously, it’s his. However, King’s cautions are overdramatic - particularly when one accounts for the catastrophic impact fighting to lessen inflation will have on our recovery from COVID 19 and its ignorance of the mistakes made after our last economic crisis. Instead, central banks must embrace a moderately higher rate of inflation and recognise this signifies a successfully recovering economy - not an overheating one.  

The best way to understand inflation lies in an explanation going back as far as Copernicus - but can best be explained with algebra - MV = PY; or in simpler terms, Money Supply X Velocity of Money (its rate of turnover) is equivalent to the price level X real GDP. Given inflation is simply a fancy term for an increase in the price level we can therefore deduct the rate of inflation at any one time using this formula.  Simply put, where money supply and the turnover rate of money is growing faster than real GDP, higher inflation will occur; on the other hand, if it is slower then inflation will fall. 

King’s case that inflation is going to be problematic is predicated on the observation that the money supply and the velocity of money has grown during the pandemic. Huge increases in Government spending and a £450Bn quantitative easing program has seen money supply soar leading to inflation fears becoming rampant. Or back to the formula - M & V have risen. However, these fears seem to underestimate the size of the whole COVID 19 has ripped into our economy. Indeed, the output gap - the difference between current activity and the potential level of activity associated with stable inflation - is as much as 0.9% of GDP and isn’t expected to return to 0 until 2025 at the earliest. As Anna Schwartz and Milton Friedman famously observed, increased money supply actually helps to increase real GDP - or back to the formula growing M is increasing Y. To be blunt, the best evidence we have doesn’t seem to suggest that any upcoming inflation is going to be stable - and thus unproblematic. 

Abstract discussions about the rate of inflation ignore the huge effect action taken to prevent a rise would have on ordinary people. The primary vehicle the Bank of England has at their disposal to decrease the rate of inflation is increasing the bank rates - as this will help increase interest rates. However, the real damages of such a decision must not be underestimated - it can result in those wanting to take out credit after the hike will be less likely to obtain it, and the lucky few who can get loans may be put off due to the harsh amounts of interest they’ll have to pay on the debt. 

This is a problem because our economy is dependent on credit. If businesses and individuals can’t take out loans they often stagnate or die. Firms hoping to expand cannot buy the new equipment they need to do so. Companies going through tough times can’t ensure staff are paid. Individuals wanting to buy a house will find it harder to do so. And all of this manifests in lower rates of investment, GDP, and more people unemployed

After the Global Financial Crisis, these fears had dramatic costs across Europe that we must not forget. During the Spring of 2011, Europe’s recovery was going as well as the United States’. However, an oil shock caused a temporary rise in prices prompting central bank intervention by raising interest rates across the Eurozone. Predictably, this slowed down the recovery from the Global Financial Crisis across Europe and caused GDP growth to stagnate. This spike was transitory - it did not show the economy was overheating or we were risking collapse. Yet exaggerated fears of inflation meant the European Central Bank was heavy-handed, helping to worsen a sovereign debt crisis and keep thousands in worse living conditions.  In contrast, the United States, who embrace full employment ignored this temporary spike and nominal GDP growth grew at around 4% every year and they emerged from the financial crisis in a much better state than their European counterparts.

As we exit lockdown and reopen the economy we must not make the same mistake. The Bank of England should and does expect a slightly higher rate of inflation during our recovery. Stable forecasted inflation tells us that individuals and businesses alike have confidence in the economy and they’re willing to spend. This is something we should embrace and celebrate - it shows that people have faith in Britain. Those economists fearing a return to 1970s style stagflation must not be allowed to stop this recovery from happening and must embrace a slightly higher rate of inflation in the short run.