We’re probably at the beginning of rampant inflation (1,050)

It is a fallacy that the official inflation rate (now 4.5% in the UK) is an accurate guide to true inflation. For anybody with the faintest trace of discretionary income (over and above normal basic spending) — and spends it — the true rate is higher than this. What the true rate of inflation is for any individual at any moment in time is almost impossible to measure because it would require keeping an accurate account of everything on which the individual spends money over several years in order to include items which are only bought at long intervals. Suffice it to say that the true rate of inflation for any individual is different from the official rate.

The reason is that the official rate of inflation is based on the composite price index. This index consists of a list of many items which most people buy most of the time. Each item is weighted according to how much of that item the average person buys. However, most people with discretionary income — and, these days, this includes almost everybody — buy items outside the official list. For someone with discretionary income over and above what is normally necessary (according to one’s social status and locality) then the individual rate of inflation is higher than the norm. For someone who has no discretionary income and, moreover, seeks cheaper alternatives of normal items (which appear on the official index) then he will “enjoy” a lower rate of inflation.

Unless an individual is actually on the breadline, he or she, at best, can only “feel” in a more or less vague way what the true rate of inflation is. At times of inflation, which is normal, then most individuals feel that the true rate of inflation is higher than the official rate. At times of normal inflation of around 2% — what governments usually aim for in order to reduce their debts steadily from year to year — then most people will actually be experiencing a rate of inflation of anything from 2.1% upwards. This applies even if many of the items on the composite price index are actually decreasing in price (as, for example, food and many household items have been for the last 20 years or so even while inflation has been growing).

The reason for this is that any individual is likely to be buying goods which don’t appear on the official list of normal consumer items. The total list of items that people buy in the aggregate is far larger than the official list. So an individual can only feel what the rate of inflation is. My own feel of the present rate of inflation in the UK, as it affects me, but also more widely from general observation, is that the true rate of inflation is already more like 6% or 7% rather than the official rate of 4.5%.

Be that as it may, we already know from the history of inflation in many advanced countries in the last century that 4.5% is already at the hinterland of accelerating inflation. Because governments have been the originators of currency in the last century then they, and only they, can reduce inflation. And it takes discipline on their part to reduce the rate to inflation to the politically acceptable levels of around 2%. In the case of the present 4.5% (and similarly in the US) it would probably take three or four years at least.

Governments have two ways to reduce inflation. Firstly, they can inhibit banks from creating too much new money (credits) by insisting that the banks holds a percentage of their money in reserve (a “fractional” reserve). Traditionally, a safe reserve is between 10% and 20%, though some would say that it ought to be 100%. However, most banks in the UK (and all other advanced countries) don’t have any real reserves. They only have notional reserves on their balance sheets by inflating the value of the collateral which lenders have lodged with them in exchange for their loans. Although most banks now have lashings of money or other assets lodged with their central bank as their fractional reserves, their true balance sheet reserves are negative. This is, of course, something that neither governments or most banks dare reveal because it would expose their joint negligence over many years. So, in all advanced countries at the present time, this method of reducing inflation is hypothetical, though some emergent country governments such as China or Mexico increase the required fractional reserves from time to time as a tool to reduce inflation.

Secondly, central banks can increase their basic interest rate which then becomes the platform on which banks build higher rates for their borrowers, particularly so for two of their most important classes — mortgagees and small businesses. The basic interest rate in the UK at present, and for the last two years, is 0.5%. It is, in effect 0%, but this couldn’t be adopted officially because it would expose the central bank (that is, the government) to total ridicule by even the least financially educated of the public. Nevertheless, the Bank of England cannot raise its interest rate even by 0,25% at present because thousands of additional homes would be foreclosed by the banks and building societies, and thousands of additional small businesses either couldn’t grow or would go into liquidation. Unemployment would go up and even a moderately stable government, such as the UK’s, would start rocking. This particularly applies to the most important single country in the world, America, at the present time. President Obama dare not contemplate the slightest increase in the Fed rate, now or in the immediate future, or else he will never have a chance of re-election in 2012.

So there we are — as we have been for the past year or so since the credit-crunch — poised between gathering inflation and the possibility of the present recession turning into full-scale depression. Economists are divided at present between a minority of those brave individuals such as Tony Weale and Spencer Dale in this country who advocate an increase in interest rates, however small, as at least a gesture towards ultimate economic sanity, and those who are more sympathetic to the plight of politicians. My bet (though not my money) is on the latter view prevailing until we reach anything between 10% and 15% (real) inflation when there’ll be no other alternative.

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