The negative effects of inflation
Inflation has a wide range of negative side effects. Fluctuations in inflation can make it difficult for consumers and companies to distinguish between overall inflation and changes in the relative prices of individual products. This tends to weaken price awareness, which is one of the fundamental premises of competition. It becomes more difficult to predict how prices will move in the future, and this makes it more difficult to make sensible decisions about investments or other uses of money. Such uncertainty limits the informational value of price changes and restricts the ability of the market economy to allocate limited resources effectively. The interaction of inflation and the tax system makes this situation even more complicated. The tax system, for example, tends to give preference to today at the expense of future consumption (that is, savings), and to favour investment in residential housing over other types of investment. These effects become stronger as inflation rises higher.
High inflation also exacerbates social inequality and weakens social cohesiveness. Income is transferred from individual owners of savings to professional investors, who are able to shelter themselves from inflation; from low-income groups to high-income groups; and from renters to homeowners, to give just a few examples. This shift generates tension and conflict among various income groups, and the deck is stacked against those who are weaker. High inflation and wildly fluctuating prices therefore have unfortunate economic and social consequences, which become increasingly more serious as inflation rises and grows more persistent. Historical experience also shows that the cost of bringing such inflation under control could be substantial and could emerge as reduced output and income. This temporary cost is small, however, in comparison with the permanent loss that accompanies persistent inflation, as is noted above. For this reason, central banks have been tasked with the primary objective of controlling inflation. A detailed discussion of monetary policy can be found in the article by Thórarinn G. Pétursson, “The role of monetary policy,” which appeared in the Bank’s Monetary Bulletin 2007/3.
Why is the inflation target 2½%?High, volatile inflation has adverse effects on the economy. It can reduce investment and employment opportunities and exacerbate social inequality. By the same token, inflation that is too low can also be detrimental. Because it is difficult for firms to lower nominal wages, their ability to pay their employees is reduced when the price at which they sell their products and services rises too little, or falls. Under such circumstances, firms must either hire fewer workers or even lay off staff in order to cut wage costs. In this way, excessively low inflation causes the employment level to fluctuate more when economic shocks strike, which is costly for society. The same can be said of real interest rates, as it is difficult to reduce nominal rates far below 0%.
Setting a target of 0% inflation increases the risk of more frequent deflationary periods. Long-lasting deflation causes the real value of non-indexed debt and debt service to increase. Because the price of goods and services has fallen while the balance of non-indexed loans does not change with the price level, companies must produce and sell more goods and services to be able to cover loan their loan payments. As a result, borrowers must actually pay more, even though the amount of the loan in krónur terms has not changed. This can cause financial distress and bring about an economic contraction.
Households and businesses may respond to such a situation by delaying spending decisions in the hope that prices will fall even further. In that case, both manufacturers and retailers sell fewer goods and services, which means that their revenues and profits decline. The companies then respond by cutting production and either hiring fewer workers or laying off staff. Unemployment rises higher as a result, and the people affected by it have less income, which prompts them to buy even fewer goods and services, and so forth. This deepens the economic contraction still further. Historically, deflationary periods have created problems, and it can prove difficult to deal with the vicious cycle of deflation and economic contraction.
The consensus is therefore to aim at an inflation rate that is low but still somewhat above 0%. According to the joint declaration made by the Central Bank and the Government, Iceland’s inflation target is defined as an inflation rate of 2½%. This is in line with the practice in other advanced economies, where inflation targets are typically set at between 2% and 2½%.
Monetary policy and price stability
It is generally considered to be the case that when inflation is relatively low and stable, long-term monetary policy only affects nominal variables such as inflation, nominal interest rates, and nominal exchange rates, whereas it does not affect long-term growth in real variables such as GDP growth and employment. Therefore, in the long run, monetary policy mainly determines the monetary value of these variables; i.e., the general price level. Inflation gives an indication of how the monetary value of assets changes over time; that is, how the power of money to purchase them changes. It is in this sense that inflation is said to be a monetary phenomenon.
The most important task of monetary policy is to promote price stability. In fact, this is its main contribution to general well-being in Iceland. Inflation expectations are one of the most important determinants of inflation levels. Credible monetary policy is the key to establishing a firm anchor for inflation expectations and reducing economic volatility in Iceland. The clearer monetary policy objectives are and the more effectively the legal framework supports these objectives, the more successful monetary policy will be.