ECB, BOE Hold Rates Steady

The European Central Bank and the Bank of England both decided yesterday that interest rates in the economies for which they have responsibility were properly set. In the eurozone, that means rates stayed at 2.5%, and in the UK, they remain 4.5%. Despite inflation pressures brought on by oil price increases, these were the right moves.

Ever since the oil shocks of the 1970s, the central banks have worried about the effect of inflation rising rapidly because of sudden surges in the price of crude oil. Inflation, like most other things, is relatively harmless in moderation. One could argue that a little bit, in fact, is better than none at all because deflation has its own set of troubles, not least of which is central bank unfamiliarity with fighting it. However, inflation after a certain level makes life more difficult and genuinely destroys the saving of most.

According to Economics 101, inflation happens when too much money chases too few goods. In other words, money becomes less valuable than other commodities. However, there are different reasons for that happening. And depending on the kind of inflation one has, there are different prescriptions for dealing with it.

The most familiar is demand-pull inflation. This occurs when wages out pace productivity. This means consumers can spend more, and they start bidding against each other for goods and services that haven't risen as much as the workers' paychecks. Higher interest rates here slow that down by making it more expensive to borrow for big-ticket items. At the same time, a highly graduated income tax will do the same fiscally. Conservatives hate this “bracket-creep,” (when people earn more they move into a higher tax bracket and pay a higher rate of taxation) but economically, there is no difference between this and higher interest rates.

Less familiar is asset inflation, which is best exemplified by speculative bubbles. Oil is particularly prone to this, as any glance at an oil price chart for the last 30 years will show. Currently, high oil prices result in a transfer of wealth to owners of oil, while everybody else who consumes oil (the entire developed and most of the developing world) pays more. This has the same effect economically as a higher tax rate.

Raising interest rates has the effect of slowing economic activity in either case. If one has demand-pull inflation, that is the very thing to do. However, if one has asset inflation, especially higher oil prices, higher rates of interest compound the slower economic activity brought on by this higher “tax.” In controlling inflation, the first thing to consider is what sort one faces. The ECB and BOE appear to have this right. One hopes the Fed will pay attention.

© Copyright 2006 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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