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LGT Investorama: The two sides of inflation

March 6, 2017

In general, the less inflation the better; however, higher inflation is on the wish list of many economists at the moment.

Read the latest edition of LGT Investorama
Read the latest edition of LGT Investorama

“Inflation is when you pay 50 dollars for a 30-dollar haircut – one that you used to get for 15 dollars when you still had hair,” as the American humorist Sam Ewing once said. Economists are more technical in their explanations: they define inflation as the process of sustained increases in the money supply compared to the supply of goods, which arises from a causal complex in the economic system and which in turn impacts it.

The witticism by Ewing clearly points to the negative effects of inflation – the sometimes rapid and uncontrolled increase in prices. Money newly created by the central bank goes into circulation among market participants. If the quantity of goods remains the same, the additional demand generated by “cheap money” leads to rising prices. This is not just a current problem. Even the Roman Emperor Diocletian was confronted with exploding prices. He attempted to prevent price increases and to stop the economic decline of the Roman Empire by issuing The Edict on Maximum Prices. His failure to stop prices from rising has not stopped democratically elected officials in later centuries from using the same means. The wage and price controls that the US president Richard Nixon wanted to use to combat the high inflation rates of the 1970s did not have their desired effect, either.

The price level is calculated using the cost of living index, which is based on a hypothetical consumption basket. This is not without problems, as consumption patterns are constantly changing and income groups differ in their consumption behavior. There are also price increases in areas not covered by the cost of living index.

But inflation is not always undesirable. A modest amount of inflation is necessary to keep a market economy well lubricated. That’s why most central banks set an inflation target of about two percent, including the US Federal Reserve and the European Central Bank. This represents a good compromise between two opposing objectives. On the one hand, there should be sufficient distance from zero inflation in order to avoid a dangerous deflationary spiral; on the other hand, the overall economic costs of inflation should be kept as low as possible.

Author: LGT Capital Partners

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