FOOL'S EYE VIEW
Low Inflation Hurts - But It's Good For You

By Rob Davies
August 8, 2002

We have an ambivalent attitude to inflation. When petrol and food prices go up we hate it but, not surprisingly, we are delighted when wages increase and the value of our house rises. Ideally we want the latter without the former, but is that possible?

Before we answer that question we should think about what inflation actually is. As with so many financial terms there are a number of definitions, but the one I like best is this.

Inflation is a fall in the value of money.

That simple phrase encapsulates the problem of trying to define it. In the UK we have many different measurements for inflation, each one trying to get the "right" answer by tracking the ideal combination of goods and services that best reflects the experience of the public. But once we understand that the problem is not what we buy but what we buy it with then the issue becomes clearer.

We don't have to have inflation. Indeed for many centuries prices hardly changed at all. But the twentieth century, and the repercussions of fighting horrific and expensive wars, led to inflation becoming institutionalised as a way for governments to spend more than they earned. Because they control money governments can create more very simply. But they can't create wealth so easily. So if the amount of wealth remains constant, but there are more coins and notes, it follows that each unit of currency will buy less wealth and the currency becomes debased.

It's a scam that includes everyone because it has the effect of appearing to benefit all and sundry. Manufacturers raise prices, shops pass these on and consumers can afford to pay more because their pay has gone up. Oh, and the government gets more tax. But the loaf of bread, or the house they buy, is unchanged. It is simply a hall of financial mirrors that distorts everything.

Stuff like houses and shares are real assets, but money and loans are nominal assets. Using nominal assets to buy real assets in an inflationary environment is a one-way bet. The value of the debt is fixed in depreciating currency while the value of a real asset appears to rise. A whole generation of house buyers know and love this effect, of course, and structure their finances around it.

However, the rules of the game were changed when responsibility for interest rates was switched from governments to central bankers. These sober gentlemen are not responsible to voters and have kept interest rates high enough to virtually squeeze inflation out of the system. In the UK today inflation is down to 1.5%, on the measure that excludes mortgage interest. That is low enough to be considered not relevant for the purposes of financial planning. In that case do we need to change our approach to money matters? 

Probably, yes. If money is no longer losing its value it means the financial mirrors are less distorted and what we see is what we get. By swapping the funny money of the twentieth century and replacing it with something that might actually hold its value in the twenty-first century, central bankers have fundamentally changed the guidelines many of us have grown up with. Unfortunately, breaking our addiction to inflation involves some cold turkey. In practise the absence of inflation means that:

• Manufacturers cannot raise prices
• Retailers cannot pass on increased costs (e.g. rates) through higher prices
• Real asset prices, like commodities, property and collectibles do not rise automatically
• Debt is no longer magically reduced by the decline in its real value
• Annual pay rises are a nice memory

The fact that a mobile phone is £10 cheaper doesn't help much if you've already got one. On top of that the car and mortgage payments no longer shrink like they did in the old days when you got regular pay rises. Put like that, inflation doesn't seem so bad after all. But we don't have the option of choosing any level of inflation. We just have to live with the world as it is. To be honest few of us would volunteer to return to the inflationary days of the seventies, but adjusting to the new world is painful.

These day's debts don't go away unless you pay them off. The focus is moving from interest cover to capital repayment, and that applies as much to large multi-national companies as it does to individuals. In a low- or zero-inflation world investors need to look at their portfolios with a fresh eye and ask some brutal questions about the ability of a company to raise prices and deal with its balance sheet. The good news that prices for things like phone calls has dropped has to be balanced by the reality that telephone companies are suffering from falling prices. In that case we have to ask how the business can grow.

The same argument applies to individuals. When we take on debt we need to be sure we can repay the capital, not just the monthly payments. And be realistic about your salary prospects before committing to long term saving schemes. Will you really be able to save as much as you think if you don't get a pay rise?  Low inflation is certainly a good thing, but adjusting to it can be painful.

A version of this article was originally published in April 2001.