Do Central Banks Want Higher Inflation?

Oct 8, 2011

- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
The deterioration in global markets that has occurred over the last two months has finally prompted central banks to take action. First, we had the US Federal Reserve announcing operation Twist, which involved buying long-term government bonds financed with the sale of short-term securities. This was a money neutral measure, meaning that no new money was created in the process.

This week, both the ECB and the Bank of England announced further monetary stimulus. The ECB decided to purchase 40 billion euros worth of bonds from banks and extended its liquidity program. The Bank of England expanded its quantitative easing program, deciding to purchase an additional 75 billion pounds worth of long-term government securities. All these measures have had a positive impact on global markets.

Western economies are facing two major problems at the moment. First, they are heavily indebted and current debt levels are unsustainable in the long run. Second, economic growth remains slow and unemployment is still high. The financial markets have seen increasing volatility and large declines as a result of these two problems.---------------------------------------------------------- Free Video ----------------------------------------------------------

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So how do these problems get fixed? And how does the monetary stimulus provided by central banks help to fix the problem? Quantitative easing has its supporters and opponents. On the supporting side, quantitative easing will have the effect of lowering long term interest rates, thereby increasing the incentive to borrow and invest and thus boost economic growth. On the opposing side, quantitative easing will simply lead to higher inflation, as it involves printing large sums of money.

Central banks surely recognize both issues, and are certainly aware of the risk to increased inflation. Why then is quantitative easing such a popular policy? Of course, there are the positive points mentioned earlier, such as lower long-term interest rates. It also has the added effect of boosting stock markets, and boosting risk appetite in financial markets generally.

How about inflation? Well, perhaps central banks wouldn't mind a bit more inflation. Perhaps they are so keen on quantitative easing because they actually want higher inflation, rather than trying to avoid it. As we'll see, higher inflation may not be such a bad thing given the large debt problems faced by Western economies.

When a country is faced with excessive levels of debt, they have essentially three options. First, they can pay it back. Second, they can default. And third, they can inflate it away. We'll discuss the pros and cons of each, and see that the inflation option is probably better than the first two.

For a country to pay back its debts, it would need to see significant spending cuts and tax increases. This is already occurring, though not nearly to the extent that is necessary. This is in theory is the correct option, though from a political perspective it is not easy. Large cuts in government expenditure and tax increases can lead to a short-term recession and social unrest. For this reason, it is difficult to implement.

The second option of default could potentially be quite catastrophic. Financial markets would certainly crash and this too could lead to a recession. For a country like Greece, a structured default may be okay because the country is quite small. However, for larger countries like the USA, Spain, UK, etc., default would lead to a huge crash in global markets. Clearly this is something to avoid.

The final option, which is to inflate away the debts, looks to be the easiest of the three options. By having higher inflation while the nominal value of debt doesn't change, the real value of the debt falls, making it easier to pay back over time. Extremely high inflation will obviously cause major problems, but inflation rates in the range of 7-10% would not be as bad. It is easy to implement as central banks can create money, and it helps the debt situation over time.

Thus, central banks want higher inflation. The reason they are happy to create more monetary stimulus anytime the markets are doing poorly is that they are not worried if inflation goes up. Higher inflation punishes savers in the economy, but it does partly alleviate the debt problems. Furthermore, it won't create a financial crisis or panic. In fact, stock markets do well when there is additional cash in the system.

The most likely outcome of the debt problems in Western economies is higher inflation. It is not necessarily the best option from an economic perspective, but it is the easiest to implement and the effects are spread out over a long period of time. Central banks know this, and thus are happy to continue monetary stimulus as long as they feel is necessary.

is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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4 Responses to "Do Central Banks Want Higher Inflation?"

Rakesh

Oct 10, 2011

Rustam, It was certainly not written by Bill. See the top "- By Asad Dossani, Author, The Lucrative Derivative Report" . Asad has been trying to paint a positive picture on the whole situation. This is just one such effort. While what is written makes sense from the central banks perspective, it nicely hides the impact of those decisions. Its like the Lion telling a deer that it has nothing to fear when it enters the forest. But of course if the deer smart, it will arrive at it's own perspective. Not the Lion's (Central bank)

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PALLAV VED

Oct 9, 2011

Sir,

It means again Commodities specially Precious Metals will go up and real productive assets will be in trouble?

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Rustom Dalal

Oct 9, 2011

One way to beat inflation is to live simply,dont indulge in frills,save and invest in Equity. Companies should stick to their core strengths and not chase all and sundry non core businesses.

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Rustom Dalal

Oct 9, 2011

I really wonder if Bill Bonner wrote this! Quite a U turn

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