We all know from a personal point of view inflation is seen as bad. Bread costs more, utility bills go up and the general cost of living gets more expensive. Examples of rampant oil price induced inflation in the 1970s and 1920s Germany where citizens carrying wheelbarrows of cash just to buy a loaf of bread are well known. More recently we have seen runaway inflation in countries like Zimbabwe where it was forced to issue 100 trillion dollar notes (2009). Inflation increases the opportunity cost of holding cash and can discourage investment and savings as uncertainty over future prices increases. If inflation is rapid enough, it can create shortages of goods as consumers start to hoard commodities and assets. Inflation for bond investors is bad as detailed in this recent article by PIMCO.
So why do the US and European central banks want inflation?
Well the answer like many things economic is not straightforward. Deflation, where prices are continuously falling, is generally seen as worse because of the experience in the US in the 1920s which took over a decade to overcome. So a moderate amount of inflation might actually be good and this is what central banks around the world are attempting to generate through quantitative easing.
Janet Yellen, the chief of the US Federal Reserve, recently discussed openly why central banks want inflation. In her address, titled “Inflation Dynamics and Monetary Policy”, she discussed how low inflation “constrains a central bank’s ability to combat recessions”. The main monetary policy tool of a central bank is its ability to change the real interest rate and the real interest rate is equal to the cash rate minus the inflation rate. If inflation is higher than the cash rate then the purchasing power of cash is eroded. Negative real interest rates provide a stimulatory effect because it gives investors holding cash an incentive to spend it, thus adding to economic activity and supporting a recovery. But as Yellen put it, “the federal funds rate and other nominal interest rates cannot go much below zero, since holding cash is always an alternative to investing in securities.” In other words, if banks have negative interest rates and it costs holders to deposit money in the bank (as has been happening in Europe – see our article on this, it drives investors to hold cash but drains money from the banking system. This limits how low (or negative) central banks can make interest rates and limits the policy levers central banks have to manage their economies.
The Bank of England has an economics team which is encouraged to produce thought leadership pieces and one of the more radical thinkers is Andy Haldane. Recently he spoke to the Northern Ireland Chamber of Commerce about the exact problem of central banks being effectively limited to cutting rates to zero or mildly negative. His option? Get rid of cash and remove the ability of people to withdraw it from banks and hold on to it. It’s a radical idea and you can read more about it here in a Financial Times article.