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Thursday, April 24, 2008

The threat of inflation

With the threat of rising inflation looming over the UK at the moment, now is a good time to get an understanding of the problems facing the Bank of England.

Firstly what is inflation?

Inflation is a rise in the general level of prices over time. It may also refer to a rise in the prices of a specific set of goods or services. In either case, it is measured as the percentage rate of change of a price index.

Inflation is not a simple phenomenon. If it is due to excessive domestic demand, this can be controlled by tightening money supply - higher interest rates, tighter lending rules. Asset inflation - the housing market falls into this category.

But we should not count asset values as inflation anyway. Inflation should be applied to the cost of consumables as this is what really erodes the value of money savings which is saving for future consumption.

Will this affect the price of housing?

As a society we value more people to get on the housing ladder so the bank could in fact fine tune its policy by having a two tier interest rate structure it offers to mortgage lenders - one based on the value of mortgages on its books to first time buyers and smaller mortgages, another for buy to let and larger mortgages.

If your currency falls in relation to overseas ones, you get imported inflation as imports are more expensive. You can only control this by increasing the value of your currency or by reducing the proportion of imports in the basket you purchase.

Higher interest rates will push up currency values. But higher prices may reduce consumption. If overseas prices are going up because of demand and supply issues, then nothing you can do will decrease those prices. But belt tightening can be induced by tighter money policy. This may not be required if the price effect reduces consumption anyway.

If inflation is not due to booming domestic demand (and asset inflation contributes to this so perhaps house prices should be allowed to come down somewhat) then since you cant influence overseas prices or your currency easily, perhaps it is time to think outside the box and look at increasing efficiency in usage, cutting waste, increasing local production, substitution etc.

That would be a long term achievement and would have benefits lasting well into the future. But this requires microeconomic policies which are far more thought and attention consuming and no one seems to have an appetite for that.

If you have any questions on this article or others like it, please feel free to contact Solution Mortgages on 0845 123 1260 or visit us online at http://www.solution-mortgages.co.uk/