Central bankers want you to believe they are comic book superheroes engaged in a Manichaean battle against inflation. This ignores the detail that their actions—incontinent monetary policy for more than a decade—have contributed to the problem. Close scrutiny reveals the shallowness of the entire debate.
Inflation is supposed to measure the change in prices of goods and services. But of what? Measures use a basket of items that frequently bears little resemblance to what the average person consumes. In the 1980s, the finance minister of a Latin American country experiencing hyper-inflation justified the exclusion of certain items whose prices were rising rapidly on the basis that they were so expensive no one could afford them anyway.
Measurement problems abound. The housing component, frequently constituting a quarter of inflation indices, often uses the owners’ equivalent rent, which is highly subjective, with a small change in weighting—such as for single-family homes—affecting the outcome. There are multiple measures—consumer price index, producer price index, GDP price deflator— that produce different, often irreconcilable, results. Data-dependent central bankers can fit the statistics to policy.
The effects of goods and services inflation are not straightforward. It can affect living standards, especially where nominal household income does not keep pace with rising prices. It disadvantages those on fixed incomes. It can reduce savings. Where compensated for by interest rate rises, it affects borrowers, crimping spending or, in extreme cases, resulting in default. Rapid price fluctuations create uncertainty around consumption and investment decisions. It exacerbates social inequality, favouring asset-owning higher-income groups.
But despite protests to the contrary, central bankers need inflation. Rising prices help growth, increasing consumption as buyers accelerate purchases fearing higher future costs. It can increase a country’s competitiveness through currency devaluation. Higher inflation helps deal with debt. It would increase taxes and business revenues, and reduce purchasing power, which lowers real debt levels. Devaluation of a currency can reduce the value of debt held by foreigners. Inflation boosts the value of real assets, thus securing borrowings and reducing the risk of loan losses.
For policymakers trying to engender growth and manage unmanageable debt levels, inflation is preferable to deflation. Falling prices can lead to deferral of spending. Deflation reduces incomes, revenues and tax receipts, making it more difficult to service debt that would also increase in real terms. It would reduce asset prices, decreasing wealth. Where used as collateral for borrowing, lower asset values would increase risk.
The true sources of inflationary pressures are frequently ignored. Milton Friedman’s nostrum that inflation is anywhere and everywhere a monetary phenomenon is misleading. Inflation is a real-economy phenomenon reflecting misalignment of demand and supply of goods and services.
Over recent decades, policymakers have equated consumption, often funded by borrowing because of stagnant incomes, to better living standards. In the words of British economist Tim Jackson, “[We spend money] we don’t have, on things we don’t need, to create impressions that won’t last, on people we don’t care about.” Demand shows no signs of abating, especially as emerging countries move up the development scale.
Supply-side factors, especially productive efficiency, are crucial. The emergence of vast production capacities in China and low commodity prices kept goods inflation in check. Longer term factors are now asserting themselves. Sovereignty and security concerns are likely to restrict trade. Heavily subsidised on-shored production, which contradicts the basic principles of comparative advantage, will affect prices. Shortages of crucial elements—water, energy, raw materials—are evident. Productivity improvements have slowed and are unlikely to return to previous levels.
Given these factors, central bank efforts to manage inflation through interest rates and money supply changes are puzzling. While it may at the margin affect debt-funded demand by changing borrowing cost and supply of credit, monetary measures have limited influence over underlying spending, especially the constraints around supply. Other possible measures such as administrative controls, income and price policies, or rationing have limited efficacy and are anyway anathema to market-favouring ideologies. Given the lack of instruments to directly influence demand, improve productivity or efficiency, enhance trade, and increase or decrease the supply of real goods and services, central bank efforts to control inflation are unlikely to be successful.
Perhaps the most egregious shortcoming is the failure to differentiate between different inflationary pressures. German economist Kurt Richebacher differentiated between price rises in consumer items and financial assets. There is frequently a trade-off between the two. Asset inflation is more dangerous as it increases the risk of financial instability, primarily from debt-funded investment bubbles.
While citizens complain about rising prices of consumption articles, those who own assets rarely protest about increases in value of property or investments. This might explain why policy makers seek to rein in consumer price pressures while ignoring asset inflation. All this makes central bank inflation targeting—pioneered by New Zealand in 1990—the worst kind of groupthink. If one central bank adopts it, others feel obliged to follow.
A target inflation level of 2-3 percent, commonly used by central banks in developed countries, effectively locks in an equivalent degradation in the value of the currency that, over long periods of time, represents a substantial loss in purchasing power. Price stability itself (which is inconsistent with the normal positive price rise target) is an absurd concept as the amount paid and received for goods and services is the mechanism for equating demand and supply.
In reality, inflation targets have become an artificial performance indicator for central bankers. Like all such metrics, they have limited utility and can distort outcomes, sometimes disastrously. The discourse around inflation merely confirms the view of John Kenneth Galbraith that the major purpose of economics is to provide employment for economists.
(Views are personal)
Satyajit Das | Former banker and author