Inflationary Trap - A Regressive Inflationary Cycle

08/03/2012 09:19 | Updated 06 May 2012

In recent years the level of debt finance within the majority of business entities has increased significantly. This is often put down to having a consistently low rate of interest allowing low borrowing costs and encouraging a more highly geared economic environment.

This steady level of interest has occurred as a result of the Monetary Policy Committee's (MPC) decisions, which are set with the aim of maintaining a rate of inflation of two percent. As there is a known positive correlation between the rate of inflation and the rate of interest the interest rate has also remained at a constantly low level.

This has been seen by the economic community as a sound economic strategy as it produced over a decade of seemingly strong economic output. However in recent years concern has been raised over the increasingly higher levels of debt and the long term affects that this will have on the economy.

This fear has mainly appeared in the personal side of finance and the cost of the level of private borrowing private citizens of Britain are encountering. Although the business side of the economy has not been ignored most of the emphasis has been on private borrowing, repossessions and bankruptcy.

Unfortunately the emphasis may have been put in the wrong direction as it is possible business sector borrowing might be hit more severely than private sector borrowing. This is due to the necessity of debt in the business world for almost all business entities to function. Problems will arise if the debt finance, which has been available in recent years, is taken away or becomes more expensive.

This high level of debt in the business environment has the danger of tipping the economy overboard if the cost of that debt is to increase in the future. If the interest rate increased the costs of many businesses would increase over night. This would mean that the business would either have to become leaner, reduce staff numbers or may even cease to operate altogether.

Although this might seem like a far off problem that may only occur if interest rates increase significantly, there is a worry that just one or two interest rate rises could create further interest rate rises due to the knock on affects of the initial interest rate rise. Say for example interest rates rise by a quarter or half a percent this might make businesses costs increase enough for them to have to cut their staff and as a result their productivity.

This reduction in the productivity will reduce the level of output in the economy and as a result push prices up creating an inflationary gap. If the MPC attempts to meet its target of two percent inflation it will have to increase interest rates to close the excess inflationary gap.

This will then increase the cost of running businesses as they will now have to pay back further interest payments and may have to cut back production, reduce staff levels and eventually cease trading completely. This will then reduce output again and the MPC will have to increase interest rates again to close the excess inflationary gap and maintain the target of two percent that they have set for inflation.

If this was to continue again and again it would create a regressive inflationary cycle that continues to demand higher interest rates to maintain the two percent inflation target set by the Bank of England. This could damage the economy in a way that would not be rectifiable with the current methods of economic control as monetary policy would be the cause of the problem.

Most of the economic community would probably argue that by using the two percent inflationary target the economy would be stable enough to prevent the need to have a high enough interest rate to start this scenario. However inflation is not always controlled by matters that are in our hands. The level of output in an economy can create inflationary gaps due to scarcity, which is not necessarily preventable.

For example oil price increases can reduce the output of the whole economy due to so many industries having a dependency on the energy that the oil produces. If oil prices were to increase it could kick start this regressive inflation cycle scenario also natural disasters could damage the infrastructure of the economy or ruin crops also reducing output, which in turn pushes prices up.

Other uncontrollable factors include war, civil unrest, tariffs and trade embargoes. All of the above factors could create an inflationary gap significant enough to push interest rates up to a level that starts the regressive inflationary cycle. This could however be avoided if the MPC altered its targets and did not have to maintain inflation at two percent or if there was another way to control inflation that was not dependent on interest rate alterations.