Thursday, 2 June 2011

Inflation - A fine and fitting thing?

Many will point to various factors contributing to the high level of inflation in the UK. Some blame the banks (blame them for everything) some blame quantitative easing (printing money) and some blame immigration/imports (anything outside coming in, basically).

One factor, which I believe to be core to the issue seem not to get much airtime (not in this sense):

The BoE ignoring house inflation

It’s probably worth pointing out, that I believe that if the money supply is constant, inflation plus growth = 0. Where the sum doesn’t equal zero, there is inflation or deflation. This forms the basis of my opinions – it has to be one or the other.

Let’s take housing inflation. This was, as we are led to believe caused by interest rates being too low. It’s something I agree with. So why, when these assets start to deflate, does this result in inflation. Is it the banks fixing things, is it QE, is it outside influences?

This is where I have another theory. Going back to my belief that the money supply will only increase through inflation or growth, you have to take a look at what drives the interest rate the BoE set, in order to keep inflation reasonable (inflation is never good anyway, so you have to wonder whether targeting 2% is a good thing overall, but that’s a story for another day).

The BoE targets the increase in prices of consumer goods via the CPI (Consumer Price Index). This is a weighted index of prices of the most popular goods and services in the UK. Sounds like a reasonable benchmark, doesn’t it.

Growth is ignored from the calculation, but then again growth means everyone gets more value for their money in constant terms, so that’s what should happen. If the economy grows by 5%, against everyone else, then you’d expect the exchange rate to follow suit. It’s reasonable therefore that the government targets inflation and allows growth to do what it does.

So, house prices, if they’re not inflation, they must be growth right? Well, not in the truest sense of the word...well, not in any sense of the word. So, why didn’t the government do anything to target this ‘house inflation’. This is the question, and where my thought process leads to.

If you’re publishing inflation and growth numbers, markets react and the consequences will meet expectations at a macro level. The government however ignored this increase.

For me, housing inflation is part growth, part inflation. Why so? Well, it’s essentially geared investing, just like fractional reserve banking. Consumers can gain, through gearing. Some of this is cashed in (growth), some is never recognised (inflation). Causing everyone to pay a higher price

Let’s say for arguments sake, 20% of that ‘increase’ over the ten years from 1997-2007 was inflation. This is inflation that has never been accounted for. Things go crash bang, and the government has to fill the whole with QE. You can set the story how you like, “The banks failed, the market needed liquidity”. The reality for me however is that the inflation was sitting in the background, being ignored and unfortunately when the packs of cards fell down the government had to print to cover the inflation, which we will now see for some time. The over inflation we see in the coming years will be equal and opposite to the inflation that was ignored under labour.

The Great Recession didn’t cause this, poorly targeted Government policy caused it. The Great Recession just made them face the truth. Why admit it though, when you can blame it on someone else and keep spitting out The Old Lie.


Mark Wadsworth said...

"The reality for me however is that the inflation was sitting in the background, being ignored and unfortunately when the packs of cards fell down the government had to print to cover the inflation, which we will now see for some time."

I had to think about that for a couple of days, but yes, that is an excellent way of looking at it.

The original inflation in house prices (which was nearly 100% monetary inflation, not 20% as you say) means that there is an extra £1,000 billion in mortgages outstanding (or whatever the figure is) which otherwise wouldn't exist, and the flip side of that is that there must also be £1,000 billion extra cash sitting in bank accounts or invested in bank bonds etc etc.

The government is too scared of allowing house prices to crash and the bad debts to be written off (even though this would be the best thing to do) so it has to make up the shortfall somehow, and spread the losses around a bit via inflation, rather than letting small identifiable groups take the losses on the chin.

James Quigley said...

The 20% was just pulled from thin air for effect, but the more I think of it, the more I agree with your point on it all being inflation. Nearly all of it anway - you would need to take away actual inflation reported plus growth during the period, and the rest would be the damage the government is covering. Logic being, the base price would move in line with other things, if there wasn't supply issues (or other factors like excessive regulation, but it's supply as top level explanation).

Looks like about £200bn was what was required.

James Quigley said...

"for effect" should probably read as "to differentiate inflation and growth"

Mark Wadsworth said...

JQ, it wasn't as low as 20%, it wasn't as high as 100% either, you are allowed to make assumptions in this game.