When inflation is low, the general price level remains relatively stable. High, volatile inflation causes uncertainty, however, and has harmful economic and social implications. This uncertainty is costly in a number of ways; for instance, consumers’ price sensitivity becomes muted, thereby diminishing the constraint provided by competition. High, variable inflation can also make it more difficult for firms to make appropriate investment decisions. Studies indicate also that inflation can lead to reduced GDP growth over the long term.
Adverse effects of inflation
The adverse effects of inflation are wide-ranging. The inevitable price fluctuations make it difficult for households and corporations to discern between changes in relative prices and general inflation, and price awareness that is the foundation for effective competition becomes dulled. It becomes more difficult to estimate future price developments when price levels frustrate attempts at sensible decision-making about investments and other allocation of funds. This uncertainty reduces the informational value of price changes and limits the market economy’s ability to allocate limited resources in an efficient way. The interaction of inflation and the tax system exacerbates the situation. The tax system, for example, has a tendency to give preference to current consumption at the expense of future consumption (that is, savings), and to favour investment in residential housing over other types of investment. These effects of the tax system increase with rising inflation. High inflation also exacerbates social inequality and erodes social solidarity. 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 widely fluctuating prices therefore have deleterious economic and social effects, which become increasingly more serious as inflation rises and grows more persistent. Historical experience also shows that the cost of eradicating such inflation could be substantial in terms of lost output and income. This temporary cost is small, however, in comparison with the permanent loss that accompanies chronic high inflation. 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. By the same token, inflation that is too low can also be detrimental. Because it is usually difficult to lower nominal wages, inflation that is too low reduces the flexibility of real wages, which causes fluctuations in the employment level when economic shocks occur. The same can be said of real interest rates, as it is difficult to reduce nominal rates well below 0%. A target of 0% inflation also exacerbates the risk that deflationary periods will grow more frequent. Protracted deflation can increase the real payment burden on outstanding loans and thereby cause an economic contraction. Households and businesses could also decide to postpone spending decisions, opting instead to wait until prices fall still further, thereby deepening the economic contraction. Historically, deflationary periods have created problems, and it can prove difficult to deal with the vicious cycle of deflation and economic contraction. The conclusion is therefore to aim at a rate of inflation 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 other developed countries, whose target is usually in the 2-2½% range.
Monetary policy and price stability
In general, it is considered that when inflation is relatively low and stable, monetary policy affects only nominal variables in the long run, such as inflation, nominal interest rates, and the nominal exchange rate; it does not affect long-term growth in real variables such as GDP growth and employment. For the long term, monetary policy therefore determines primarily their monetary value; i.e., the general price level. Inflation can indicate how the monetary value of these assets changes over time; that is, how the purchasing power of money changes with respect to them. It is in this sense that inflation is referred to as a monetary phenomenon.
The most important element in monetary policy – and actually, its principal contribution to the general welfare in Iceland – is the promotion of price stability. 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. As the aims of monetary policy become clearer, its effectiveness will increase and the regulatory framework that surrounds it will better support those aims.