The National:

YOU have to be well over the age of 50 now to recall the time when people lived in fear of inflation. It looks as though that fear is now back again though. So, is it justified?

What is little understood is that there are at least four causes for consumer price inflation.

The first type of inflation is created by the government creating more money than can be used in the economy. It does this by running deficits when the economy is at full employment. It is also possible that quantitative easing could do this. Price increases could follow in that case. In practice, full employment at a living wage has been very rare in the UK economy and there is no indication that anything but house and share price inflation has resulted from quantitative easing. This is unlikely to be the cause of our current inflation in that case.

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Second, inflation can be caused by a shortage of supply. This is a particular problem when there is a shortage of alternatives to the product in short supply. For example, if all foodstuffs are in short supply then prices for food will, inevitably, rise. If, however, a particular consumer item is in short supply it is more than likely that consumers will substitute alternative expenditure or wait for prices to fall, meaning that the impact of this type of inflation almost invariably fades away over time. So, for example, it is incredibly unlikely that second-hand car prices will remain at their current inflated levels for very long. In fact, they might face serious price deflation very soon.

The National: Russian President Vladimir Putin addresses an extended meeting of the Russian Defense Ministry Board at the National Defense Control Center in Moscow, Russia, Tuesday, Dec. 21, 2021. (Mikhail Tereshchenko, Sputnik, Kremlin Pool Photo via AP)

Third, there are externally imposed shortages of supply. These are most common with regard to energy where producers know that they can, if they wish, create considerable disruption in markets by creating shortages compared to demand. Most of these actions are politically motivated. It is likely that Russia's President Vladimir Putin (above) is doing this with regard to gas supplies at present. There is almost nothing that a government can do to react to this if they are not themselves a producer of the product in short supply - meaning that they have little choice but to sit out such situations in the hope that they will correct themselves relatively quickly.

Fourth, inflation can be imposed by domestic political choice. For example, a government may decide to undertake a politically motivated course of action that has consequences for its exchange rate - that then results in inflated prices. Brexit is an example of this. The consequences of the impediments to trade that this has created are, inevitably, inflationary.

Given all these facts, the question really is what can be done about the inflation that we are now seeing?

The Bank of England thinks that it is appropriate to increase interest rates in response, which it has already done once, and which it has signalled it may do again. Despite this no one thinks that the official interest rate will move much above 1%, which remains as close to nothing and makes very little difference in the real world. I would in that case suggest that their reaction is wrong. Increasing interest rates can only work against consumer price inflation of the first type that I describe, which we are not seeing. Every other type of inflation requires a different response.

So, for example, the only way to tackle the threat that President Putin poses is to increase the amount of domestic energy production, which must mean investment in renewables at this point of time.

The National:

Likewise, tackling the inflation caused by Brexit means that we need to negotiate better relations with the EU so that the problems that have been deliberately created for political purposes by the current Tory government can be removed.

And as for supply chain issues, we either ride them out, or we decide to buy different products and services to reduce the impact that they have upon our household budgets. In the longer term the government also must take action to improve supply chain resilience. This will mean supporting local farmers rather than threatening to undermine them with trade deals with Australia, for example.

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In other words, if we want to tackle inflation of the types that we are seeing then we have to address their causes and not the symptoms to which they give rise. The Bank of England is, unfortunately only tackling those symptoms. In the process what it is doing is to increase the pressure on many household budgets by increasing the cost of another product that they can put in short supply, which is money itself, on which they can increase the interest rate. How and why bankers think that they can beat inflation by increasing the price of money has always bemused me, but that is what they are planning to do and that will solve nothing.

What would I do? I would encourage caution.

I still think that this inflation is temporary and will go away within a relatively short period of time. In that case panic reactions are inappropriate. A proper understanding of inflation suggests that be the case. Right now I suggest waiting and seeing is all that is required, apart from providing help to those in real need by uplifting Universal Credit, that is and by being broad-minded about this year’s pay negotiations.