Why a little inflation could do us good

15th July 2010

Why a little inflation could actually be a good thing

27 May 2010

Inflation always gets people twitchy.

It's associated with great crises – the Weimer Republic, post-war Hungary and modern Zimbabwe.

So the recent CPI and RPI statistics that showed a leap in UK inflation, propelled by higher prices for transport and food, not unsurprisingly sounded some alarm bells.

The nervousness around inflation is shown by this thread on the Motley Fool.

Wyndrum says: "Inflation is up again beyond forecast and I heard on the radio that the BoE said last year that they expected inflation to be about 1% in 12 months time, ie now. 

"I am concerned that the implications are potentially very damaging to the economy. It seems to me the danger is when we have cuts to spending, it will limit growth."

The new view

There are many who believe that such unprecedented government stimulus as has been seen over the past two years cannot help but result in inflation.

However, there are other commentators who argue that this view of inflation is old-fashioned and that, far from being the monster of popular myth, it may be a necessary route out of the current economic difficulties.

UK inflation is around twice that of Europe.

The UK has already seen huge asset price inflation over the past 20 years, particularly in the residential housing market.

The industrialisation of China and India has already generated commodity price inflation and that is likely to continue.

But commentators have been warning of the problems of the Government's over-stimulative policies for some time. Witness this article from 2009, which explores the inflation dangers facing the UK economy .  

But while I am loathe to trust economists given their recent record, it is instructive that a poll for the Guardian shows an almost universal ‘so what?' in response to the inflation figures.

Could inflation be good for the UK economy?

There is certainly a school of thought that suggests that if the pound was to devalue further and inflation rise a little higher, it might redress some of the imbalances in the economy and boost the competiveness of the UK economy.

The UK still has some significant deflationary pressures. These include weak bank lending, poor money supply growth and pressures on employment.

These are likely to become more important as some of the comparison anomalies move out of the system (these are anomalies such as the VAT fall and rise and interest rate cuts, which impacted on housing costs).

Anatole Kaletsky , for one, has argued that economists need to shake off the ‘dusty old orthodoxy' of government economic policy based solely on tackling inflation. 

In this article, he says:  "An exclusive focus on inflation by the Bank of England was fine during a period of normal economic activity.

"But it may be less successful in restoring business and consumer confidence than the Federal Reserve's mandate, which requires the US central bank to promote employment and economic activity, as well as maintaining stable prices."

If the relative advantages of inflation for the well-being of the economy are up for debate, its potential impact on portfolio returns isn't.

Inflation is bad for any type of fixed income stream because it erodes the value of that income. This includes corporate bonds and traditional gilts.

Bad news for cash

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