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In January 1965, Graeme Dorrance, the head of the IMF’s Financial Research Department, wrote an article titled Inflation and growth: statistical evidence This is the first issue of IMF staff documents.
This may not sound particularly exciting (it is not easy to read). But as the International Monetary Fund proudly pointed out when he provided his next paper, it was “widely reprinted”—I suspect you didn’t know much about IMF papers in the 1960s.
Why is it so popular? Because it makes some almost ridiculously complicated things suddenly seem simple. Dorrance introduced a magic number for economic management-2%. He said that, at least in relatively developed economies, this appears to be the optimal level of inflation to “encourage output growth.”
He believes that deflation is impossible given the interference of trade unions and monopoly pricing companies in advanced economies. Completely stable prices are possible (zero inflation), but not particularly ideal-if prices cannot fall, you need a little inflation to adjust relative prices. 2% seemed to work for this-and at the time seemed to be working for Italy, Denmark, Japan and Nicaragua.
So you have it. Fiddle with interest rates until you get your magic number, and the rest will take care of itself. Hello, long-term economic growth.
or not. At the time, not everyone was impressed by this argument-a year later, an article in the now-defunct Statist magazine refuted the whole thing, arguing that it was a confusion between correlation and causation and a comparison of average values. Careless use.
The author who suspects that there is “no connection at all” between inflation and growth says that you can’t reduce all the complications of the economy to 2%.
Fifty-five years later, most major central banks have claimed an inflation target of 2%-everyone likes magic numbers. But it seems that they are also beginning to accept the views of nationalists.
Look at Britain.Here the CPI inflation rate is 3.1%, and the Bank of England It is expected to reach its peak In recent years, it is 5%. This is more than twice our magic number-so you would think that interest rates will rise at a certain rate.
However, despite strong hints from various policymakers that we will see the benchmark interest rate rise from the lowest ever 0.1% to the 0.25% we saw on Thursday no change.
This makes some sense.The inflation we are currently seeing is based on Regarding supply issues, Energy prices rise and labor costs increase. A 0.15 percentage point increase in interest rates will not help much with these things. If they are mainly related to pandemic policies and are therefore temporary anyway, why not ignore them-let inflation naturally fall back next year as shortages become surpluses?
The first problem with this argument is that it is only partially established. First, if there is no demand for goods, there can be no supply constraints-so if a hike in interest rates will curb demand, then it will curb inflation at least slightly.
The second problem is that almost after the collective argument that “this is just a supply” was put forward, the Bank of England actually rejected it. It said that there may be no need to raise interest rates now, but “provide incoming data consistent with forecasts” and they may be “necessary in the next few months.”
There is no sign that the Bank of England expects changes in inflation drivers, so why not act now?
The third question is about reputation and expectations. For years, banks have been telling us that the inflation around us is temporary. But it also tells us now that it is “much higher” than expected.
If officials believe their magic numbers — and hope we have confidence in them — they should definitely confirm this to us, at least now that interest rates have risen slightly.
Considering that most mortgages are fixed and the family’s financial situation is quite healthy, this is especially the case, and the negative impact of a small increase will be quite limited. Pantheon Macroeconomics pointed out that the percentage of bank debt to annual household disposable income was slightly lower than in 2017 and far lower than in 2008.
On the bright side, all of this provides useful information for investors. The key point should be that although interest rates will rise from here (Quickly resolve mortgages If you are one of the few people who have not done so) there will be some epic drags in the process-and in the foreseeable future, you are unlikely to see them close to or above inflation.
Anyone who hopes to get real returns from deposits in the short term will be very disappointed. This puts us in a dilemma: how do those who wish to earn income from savings or investment actually get income.
The answer here may be to first think about why so many stocks have such low yields. Low interest rates make dividends more valuable, thereby pushing up stock prices—effectively converting earnings into capital gains.
If you can solve this problem, the next step is to think that it makes sense to treat some of these benefits as income. Keep that kind of thinking and look at Alliance Trust. The trust (large, global, diversified) has just announced that it will reset its quarterly dividend to a higher level-an increase of approximately 30% to 2.3%-and intends to continue to increase it every year.
This dividend will not be covered by the trust’s annual income from its investments-so its introduction effectively represents the conversion of some capital into income. Going back to a time when savings accounts paid interest above the inflation rate and stock market valuations seemed vague and reasonable, this might seem like a bad thing. Today, it seems perfectly reasonable.
Merryn Somerset Webb is the editor-in-chief of MoneyWeek. The opinions expressed are personal; [email protected]; Twitter: @MerrynSW
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