Adapting to low inflation.

Britton, Andrew

The first meeting of the Members Forum was held at the National Institute on Wednesday 23rd March. Those taking part in the discussion included business leaders representing the corporate members of the Institute, as well as Institute governors and staff. One of the main issues considered was the way in which the relatively low rates of inflation now experienced and in prospect in Britain and most other advanced countries would affect business and the efficiency of the economy. This note reflects what was said on that occasion, although the views expressed here are not necessarily shared by all those who attended.

The rate of inflation last year (measured by the consumer spending deflator) was 3.5 per cent in the United Kingdom and averaged 2.9 per cent in the OECD area as a whole. Although this is not quite 'price stability' it is low inflation by comparison with most of the post-war period. Moreover relatively low rates of inflation have now been maintained in most of the major industrial countries for a number of years. Macroeconomic policy is being set, by governments and central bankers, mainly with a view to keeping inflation low, leaving the problems of growth and unemployment to be addressed by other means. Nevertheless it could be argued that the memory of higher rates of inflation, last seen in the 1970s, still condition economic behaviour in the 1990s. The full benefits of lower inflation will not be realised until the process of adjustment is complete.

Lower inflation is good for economic efficiency because it makes relative prices and rates of return easier to monitor and compare. Those, for example, who make infrequent purchases will find it easier to see at a glance whether they are being offered a good bargain, if the general price level has not changed much since the last occasion they were in the market. Less time and energy need to be devoted to 'inflation adjustments'; fewer mistakes will be made. Long term contracts will be less risky; there will be less need for renegotiation.

If lower inflation is fully anticipated by the market then nominal interest rates should be lower by an equal amount. This reduces a number of serious distortions caused by high inflation and high interest rates. The flow of income, as recorded by normal accounting procedures and as reflected in actual payments and receipts, depends on nominal interest rates, not on real interest rates which adjust for inflation. Thus inflation, if fully anticipated, exaggerates the income of creditors and also overstates the expenditure of debtors. There can be little doubt that spending and saving decisions are distorted, especially those of relatively unsophisticated businesses and households. Lower inflation should make it easier to judge the true position that lies behind a set of accounts.

An example of the problem is the so-called 'front-end loading' that applies to mortgage loans when inflation is relatively high. Borrowers in the early years of the mortgage are obliged by high nominal interest rates to repay their debt more rapidly than they might choose even though the value of their property is rising. Lower inflation allows households to repay more slowly if that suits the profile of their expected incomes. The very serious problems created by inflation for insurance contracts and for pensions have been much reduced by the introduction of indexation of various kinds, but the most effective way of eliminating the problem would be to eliminate inflation itself. Add to this the complex issues of inflation and tax: it is very difficult to devise a system of taxation which is fair and undistorting in an inflationary economy. Again the best situation is to get inflation out of the system altogether.

Much of the damage done by inflation is caused by unexpected variation in the rate from year to year. The problem of 'negative equity' in the housing market can be attributed in part to this cause. Many business failures can be traced to mistakes in forecasting the future price level, rather than wrong decisions about production methods or the market for a particular product. In this case mistakes can be in either direction: businesses can fail because they borrowed heavily in anticipation of too much inflation as well as because they lent too heavily thinking prices would not rise. From this point of view market efficiency is helped by stable and constant inflation at any rate. Experience suggests that inflation which is stable and constant is generally low as well.

In two important respects, the British economy at least does not seem yet to be fully adapted to low rates of inflation. The first concerns investment and the return to shareholders. In the 1970s when inflation was high business became more accustomed to high nominal interest rates and a substantial rise in dividends every year. Although inflation was lower in the 1980s nominal interest rates did not fall by an equivalent amount because monetary policy (as measured by real interest rates) was deliberately made more tight. Moreover profits and dividends rose in the 1980s in real terms, and as a share of national income, because of such reforms as deregulation, privatisation and the ending of direct controls on prices and incomes. This history has left us with expectations that cannot be fulfilled in the 1990s.

Now that nominal interest rates are not so high it is important that firms take this fact into account when making investment decisions. If a nominal 'hurdle' rate is used to assess projects then that rate should be substantially lower now than it was say two years ago. If the real cost of capital to the firm has not changed, then the lower nominal rate of interest should exactly balance the lower rate of increase expected in product prices.

So far as dividends are concerned the lesson to be learnt is a very simple one. If total profits are to be a constant share of national income, then the growth of dividends will in the long run rise in the same proportion. Lower inflation means that national income in nominal terms rises more slowly, and the same will eventually be true of dividends. If shareholders demand more then they will see their total returns reduced by a fall in the value of their shares.

The second problem of adaptation may be more deep-seated. Wage-earners still expect an increase every year, except in dire emergencies such as those created for some firms by the recent recession. If inflation is fairly brisk then this expectation can always be fulfilled. Everyone's pay will go up, some more and some less. The fact that, in some cases, the pay rise does not compensate fully for the rise in the cost of living may be a cause of grievance, but at least the employer does not face the odium of making an actual wage cut.

In this environment pay reforms can be introduced, or an increased emphasis can be put on performance-related pay or profit-related pay, without meeting too much opposition. It is not so easy, as the public sector in particular is now discovering, to vary pay awards significantly when the total pay bill must be kept little changed from one year to the next.

The workings of an efficient market system, both for products and for labour, depend on flexibility in relative prices and relative wages. If the context is low inflation, then some prices and some wages will have to fall. The problem of adjustment is that such falls still meet with considerable resistance.

The experience of the last few years suggests that the resistance is weakening. Increased competition between retailers has resulted in quite sharp price reductions. This is not just for those food prices which commonly go up and down in response to the seasons or the state of world markets, and not just for new consumer durable goods where costs of production can fall dramatically. We have also seen reductions across the range of goods and services, as well as some quite large increases where competitive conditions allow.

In the labour market also there is some evidence of flexibility, with pay freezes or even cuts. But the slow growth of average earnings across the economy as a whole generally reflects a rather different kind of flexibility--more part-time work, more self-employment, and more flexible hours, rather than actual reductions in wage rates. The overall effect on economic efficiency of the changes in employment conditions is difficult to judge. For some businesses and their employees an explicit wage reduction might have been more appropriate.

As experience of low inflation accumulates behaviour and institutions will be more fully adapted to it. Although indexation clauses in long-term contacts are unlikely to be abolished, they may become less frequent. There may be a greater willingness to lend and to borrow for long periods, perhaps an increase in real saving and investment. Wages and prices may lose their downwards rigidity.

We will never be able to say, however, that the danger of inflation has been overcome 'once and for all'. In a flexible market economy a general excess of demand will be more likely to cause general inflation than would be the case if many wages and prices were regulated or fixed by convention. There will be all the more need for determined and skillful control of aggregate demand by an appropriate combination of fiscal and monetary policies.