In Australia, our inflation rate has been moving up fast, hitting 6.1% in figures released today. In the US, UK, and Europe inflation is even worse, in the range of 8% to 10%. At that level, it can start to become quite entrenched and destructive.
This is why Central Banks across the world are in a mad scramble to raise interest rates. Once inflation gets out of the 2%-3% range it’s time to nip it in the bud. Central banks got the inflation call wrong initially, they sat on their hands for too long and inflation got away from them.
The only real way to get inflation under control is to raise interest rates. Otherwise, inflation becomes so high that demand is destroyed because no one can afford to buy any goods or services anymore. That’s a far more precarious position for an economy to be in. Prevention is far better than the cure.
But first, why does high inflation matter so much?
From an individual’s perspective, inflation reduces your buying power, your standard of living and your wealth in real terms. If you earn $100,000 a year and inflation is 6% you need a pay rise of 6% and an income of $106,000 just to stay in the same position. If you get a pay rise of 4% you actually went backwards by 2%. If your income doesn’t keep up with rising prices your standard of living falls because you can’t afford what you could before.
From a business perspective, inflation means rising costs and unless you can pass them all on to the customer then it means your profit margins are going to be squeezed. Even if a company can pass price increases on it may result in less sales as you raise prices and so profits reduce anyway. If profits fall so do company valuations.
From a national economy perspective, if inflation becomes embedded it can destabilise the currency and if left unchecked lead to hyperinflation and economic collapse. While that’s something more often associated with developing nations, these are the types of risks that can occur if inflation runs rampant for an extended period. As living standards fall, all sort of economic and social unrest comes into play.
The bottom line is high inflation must be dealt with – whatever the cost. Getting inflation down to 5% to 7% range in the US and Europe will be a big improvement, but that’s still way too high. Inflation also tends to roar back to life quite quickly if you don’t extinguish it properly the first time. Inflation must be brought under control properly to create price stability in the global economy.
It has taken far too long for Central Banks across the world to understand that. It does appear that finally the penny has dropped. Central banks have now collectively realised they need to choose whether they tackle inflation or assist financial markets and economic growth. They can either raise interest rates and kill inflation or they can keep them low to support the economy.
But you can’t do both.
The usual situation, historically, would be raising rates in a strong economy to slow it. Often the result is a recession. The balancing act is raising rates while trying not to pull the hand brake on too fast, damaging the economy in the process. That’s easier said than done. Usually, central banks tend to raise rates too high and leave them high for too long. Usually, it is because they’ve been too slow to act initially.
The current situation is far more difficult. We’ve not seen a situation where central banks have had to raise interest rates going into a weakening global economy. The real risk, especially in Europe and even in the US is that the level of rates needed to tame inflation is higher than the economy can cope with. The potential result being that the choice to raise rates to stop inflation will have dire economic consequences.
So, the reality is this process will still take many months to play out. For some reason markets still talk about Central Banks to engineering a perfect soft landing. Great if it happens, but I’m not sure you can expect the same people who were unable to identify the problem and address it in a timely manner to suddenly thread the needle when it matters most. I am hopeful for a shallow recession but preparing for worse.
Regardless, I would rather they eliminate the threat of inflation. It will make for a more difficult downturn, but the world economy will eventually recover. If you let the inflation genie out of the bottle, then you risk all sorts of potential unintended consequences evolving and ultimately a far worse economic situation later. Unlike the past 15 years, I would hope central banks have learnt their lesson and will take their medicine sooner rather than later.
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