Angus Hanton looks at the pros and cons of rising inflation, and its effects on interest rates
Inflation is now running at about 5% pa, with interest rates standing at below 1%. The result is that, when you take account of inflation, real interest rates are negative, so that savers are seeing their savings reduced in value each year. In contrast, borrowers see the value of their outstanding loans reduce.
The combined effect is a transfer from savers to borrowers. For many older people who rely on interest from their savings to live on, this is a very disturbing state of affairs which can force them to eat into their capital. On the other hand, in generational terms these negative real interest rates create a shift in wealth from older to younger generations.
It is important because these negative real interest rates (of about minus 4%) may persist for some time. Many older savers will agree with the economist Milton Friedman who said, “Inflation is taxation without legislation.”
Inflation – confusing and difficult for old and young alike
Inflation is hard to get used to, and conventional wisdom says that older people find it hardest to cope in a world of rising prices.
Paradoxically however, older people in the UK have had early training in coping with rising prices – the inflation of the 1970s is still very vivid in the minds of the over 50s, and they have learnt ways of combating inflation that include borrowing, owning inflation-resistant assets, not holding cash deposits and using index-linking for contracts and leases.
It may be that the legacy of the 1970s inflation, followed by the last 20 years of price stability, is that the older generation has a noticeable edge over younger generations in adapting to these new conditions.
How are government pensions indexed to protect against inflation?
For those with pension entitlements, protection against inflation is critical, but the method of shielding pensioners from inflation has recently been changed: it is now the Consumer Price Index (CPI) rather than the Retail Prices Index (RPI) that will be used.
The CPI is simply a different index which is more in line with how continental Europe measures price inflation. Crucially it uses a geometric average rather than an arithmetic average in its methodology and it excludes housing costs, with the result is that the CPI is systematically lower than the RPI.
It is expected that it will probably be lower than the RPI by about 0.7% and the effect of this to pensioners over a number of years is estimated to be about 15% of total benefits.
So it matters how inflation is measured, and this change has been the cause of much unhappiness amongst the older generation of state pensioners and government employees.
Effects on national debt and contracted pension debt
As Keynes said, “By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
In the short run, inflation helps government because it reduces the value of its outstanding debt, which is mostly denominated in fixed-price pounds, and at the moment stands at about one trillion pounds with more added each year (the extra bit is the “deficit” or borrowing requirement).
This erosion of the national debt is useful to younger generations in reducing the debt burden, though it may have a longer-term negative effect: it may make it harder for future generations to borrow internationally at reasonable rates of interest if other countries start to view the UK as untrustworthy.
Inflation does not, however, reduce the value of the government’s pension commitments as these are index-linked. So the unfunded pension obligation to government employees of almost £1 trillion will not be eroded by general inflation.
Whilst negative real interest rates may help the younger generation as a whole, this is a rough form of justice: negative rates disadvantage the young person who is saving for a deposit on a flat, who will see the real value of these savings depleted, whereas the older person who has borrowed in order to invest in buy-to-let property will, as a borrower, benefit from negative real interest rates.
Higher inflation will tend to lead to negative real interest rates which will have some very predictable effects in helping mortgage payers, in discouraging new saving and in reducing the income of those relying on cash savings – so the setting of interest rates is a highly intergenerational decision.