Out of control: Inflation

By: Casper de Vries, Erasmus University Rotterdam

 

In a short series of briefs we will analyze how single minded monetary policies and misguided micro oriented risk management created today’s financial markets’ mess. The analysis also suggests numerous responses to get the world economy out of the financial bog. The first brief argues that any simple minded, explicit and specific targeting procedure is bound to fail at some point since these are always too restrictive for the complexity of the macro economy. If more attention had been given to other factors, such as money creation, then the imbalances and financial mess might have been circumvented.

 

The past two weeks proved a roller-coaster ride for financial markets and monetary authorities to such an extent that the FED within a week’s time lowered its main interest rate twice and advised the outgoing administration for a fiscal stimulus. Is this joystick economics of an election year, or has the FED advance knowledge of a serious recession in the offing? History will determine whether these actions were de-stabilizing or stabilizing. To a monetary scholar it looks like an overreaction bound to create further difficulties. How could this apparent loss of control happen?

 

Many central banks currently operate under some form of inflation targeting. Monetary policy makers believed they had found the alchemist recipe for gold, as this latest fashion in central plan banking went hand in hand with years of low inflation. Suddenly there is this wake up call from financial markets and central bankers stand ready with liquidity. Are such infusions a logical consequence of this newest operating procedure, or is something else at stake?

 
 

Ben Bernanke, the chairman of the FED. in his former academic career was the champion of this newest monetary control mechanism. An inflation targeting bank produces forecasts of inflation and revises its lending policy so as to keep future inflation levels on target. So why did the FED cut its interest rate by 75bp and by 50bp within the last two weeks? The Fed defended its moves by appealing to adverse financial market conditions and the prospect of an economic downturn. This view holds that the FED’s forecasts for the coming two years all of a sudden predict deflation and stagnation, warranting the immediate lowering of the interest rates. In this view the current policy actions by the FED are nothing but inflation targeting based crisis management to prevent a drawn out period of sluggish growth, such as Japan witnessed due to the slow response to its banking and property crisis. It is plausible that the swift action by the FED during the Asian and Russian credit crises and after the bursting of the internet bubble saved the world from a severe recession. But this came at the cost of the global imbalances. This view ignores the absolute necessity to finally let some hot air out of the American economy and turn national savings positive. It is also hard to believe that the FED has revised its inflation forecasts in a week’s time to motivate the second round cut; in its statement accompanying the second cut it only indicated it expects inflation to moderate. We do not detect much of an inflation targeting based policy response. The two interest rate cuts and the fiscal advice rather have the appearance of an election fever triggered Greenspan put. It is just hard to deny an obese child its sweet liquidity.

 

 

Demise of specific targeting procedures

History is rife with different targeting procedures, considering that the following targets have been used as intermediate goals towards reaching a central bank’s final objective: Money, domestic credit, exchange rate, nominal income and the interest rate. The Bank of England at least paid lip service to each of these targets at some point during the past fifty years. Each procedure eventually broke down because these focused too much on a single issue. For example, take the exchange rate targeting episode of EMS membership. Britain left the EMS when high interest rates frustrated the real economy. In fairness, no targeting procedure could have worked well since the Old Lady was so dependent on the UK treasury with its bias towards easy money.

 

 

Each targeting procedure has its advantages and disadvantages. Monetary targeting for example has the advantage that it manages an easily and publicly observable statistic. In this respect it is writing on the wall that the ECB in the two latest monthly reports no longer depicts its reference value of 4.5% money growth, probably because the misses became too obvious. Stable money supply is known to at least partly compensate for demand and supply shocks. The problem is that the effectiveness of the procedure hinges on the stability of money demand. But money demand has become rather unstable due to financial innovation. Hence, the relation between the intermediate money target and the final goal of price stability is unreliable. Moreover, the interest rate instrument of central banks does not have a one to one relation with the broad money statistic used by most money targeting banks.

 

 

The latest fashion of inflation targeting has the advantage that it directly addresses at least one of the final goals of central banks, price stability. The procedure derives from the popular theoretical short term macro model that holds that interest rates directly impinge on inflation and in which the effects on money are only a side show. Inflation targeting nicely sterilizes demand shocks, but overreacts to supply shocks if adhered to in principle. Targeting inflation directly also requires that the inflation measure is well defined. There is a multitude of inflation concepts like headline inflation and core inflation that excludes food and energy prices. On which measure should the central bank focus? Most definitions of inflation ignore asset prices. House prices, for example, do not rapidly show up in the inflation indices, only some imputed cost of housing services relying on rental prices are represented. Had the price of houses been used instead, then inflation would have been two percentage points higher in the UK and US over the past couple of years. This might have triggered an earlier response to the mortgage mess in the making.
 

 

A serious problem with inflation targeting is that it requires a reliable forecast of inflation over, say, a two year horizon. Because interest rate decisions by the central bank  today, take about two years to affect inflation. To the public a forecast, since it has to be somehow constructed, is a more ambiguous concept to watch than the directly observable money supply target. In particular it requires forecasting when asset price inflation will start to spill over into goods prices. Central banks maintain that they are not in the business of bursting asset price bubbles, since it is so difficult to tell when a bubble is building. But inflation forecast targeting nevertheless requires such knowledge as asset prices sooner or later affect goods prices. Central banks, by adopting the inflation targeting procedure, let themselves into the wizardry of assessing asset price bubbles. The FED’s latest cuts suggest at least it knows when a bubble has burst.

 

 

For all these reasons, most academics and central bankers agree that pure inflation targeting is not a good idea and some kind of flexible inflation targeting has to be implemented. Are we back to square one with a cocktail of targeting procedures? Not quite, there is progress. First, since the world abandoned the gold standard, we have learned a good deal about monetary policy transmission to the economy. Second, it is therefore not true that anything works when we admit that in fact we do not want to overreact and are concerned about the developments in several macro economic variables. The ECB two pillar strategy is an example of such a flexible approach. But the ECB still could improve in clarifying the structure of its economic analysis and how its policy decisions are thought to affect future inflation.

 

 

Conclusion

Any simple minded, explicit and specific targeting procedure is bound to run ashore at some point since these are always too restrictive to deal adequately with the complexity of the macro economy. Inflation is influenced by a myriad of endogenous and autonomous factors outside the direct control of central banks. By targeting inflation central banks did not (want to) see the credit explosion. Competition from Asian countries kept wages and goods’ prices subdued. Moreover, the way in which inflation indices are constructed today, house prices only very slowly creep into the indices. But financial markets inevitably find an outlet for the excess liquidity created by central banks. If more attention had been given to other factors like money creation, then the global imbalances and the financial mess might not have occurred. The ECB followed a more cautious approach than the FED, perhaps due to its two pillar strategy and singular objective. The two pillar strategy leaves quite a bit of room for ambiguity, which is not always helpful in guiding inflation expectations. But it permits the ECB to take into consideration the developments in different macro variables. The singular objective of price stability shields the ECB from pressure to stimulate the real economy. For the time being this allows for a less reactive stance on this side of the ocean.

 

Our next brief addresses the expansion and implosion of credit.

 

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* I am grateful to Matija Lozej and Oleg Tschernizky for research assistance.

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