Does the spectre of inflation exist?

Inflation wrought so much havoc in the latter half of the last century that it was described as a spectre. The prices of goods and services rose by a few tens of a percent per year. It was said that the spectre of inflation would then reduce the purchasing power of money and scare consumers.

Inflation has developed in various ways over the past decades, but the goal since 2001 has been to keep it as close to 2½% as possible, which is the inflation target that the Central Bank and the government have decided to aim for. But inflation is like various viruses and diseases: If we are not cautious and are careless in economic matters, the spectre of inflation can rise and cause havoc. Then interest rates are the best medicine to keep price increases within acceptable limits. We neither want inflation to be too high, partly because of the uncertainty it creates, nor do we want it to be too low – because then too much unemployment can set in. But if interest rates are the medicine for inflation, what then is the vaccine? One could probably say that the best vaccine against the spectre of inflation is if we can get people to anticipate that inflation will be low. People are then more likely to behave accordingly, whether as individuals, parts of organisations in the labour market or in the operation of businesses.

It is the five-member Monetary Policy Committee of the Central Bank of Iceland that now determines the Central Bank’s interest rates; it determines the medication dosage so to speak. But other parties can also affect the progression of the disease. Through their decisions on government revenue and expenditure, politicians also have an impact on overall demand in society and thus on inflation. The same applies to associations of enterprises and workers that determine wages and benefits, since large wage increases can increase demand and inflation. It is therefore the joint task of the Central Bank, politicians and labour market institutes to put the ghost of inflation to rest.