Monetary Policy Reform: Inflation Targeting should be Rolling and it should be Zero
2021 is not proving to be a vintage year for central banks, and particularly the Bank of England. With so many blunders and a complete unwillingness to take responsibility, Liz Truss’ calls for reform look like a necessity. Assuming the bank is going to maintain responsibility for price targeting, how should those reforms look?
Firstly, the target should be rolling. That means periods of excess inflation would have to be offset by periods of below target inflation and vice versa. Thus ensuring long-term inflation averages the mandated target.
There are two major advantages of a rolling target. Firstly it allows central banks to maintain credibility, even when inflation or deflation deviates from its target. That sort of strict credibility is invaluable in controlling price expectations, which are often the driver of inflationary spirals. In fact, when it comes to expectations, a rolling target within a credible central bank is anti-fragile and self-correcting: the greater the deviation gets to one side, the greater the expectations for the offsetting deviation that lies ahead.
Further, the current system is commercially unsound. No employee would accept a job where their wage fluctuated anywhere between about zero and £18,000 a month, with the only assurance being that now and again, it might hopefully be about £2000. Equally no one would subscribe to a magazine where the cover price could be 50p one month and £20 a few months later! Price volatility may be inevitable, but we should at least be able to know what the average will be. A rolling target would allow businesses and the public to plan for the long term. This is an explicit mandate of the Bank. However the current system comes nowhere close to achieving this.
In addition central banks should set their rolling target at 0% inflation.
The two great cornerstones of western civilisation - free markets and democracy – can only function where there is transparency. A pay rise should be a pay rise. A capital gain should be a capital gain. If the government wants more public spending, it should make the case for it, not sneak it in via stealth taxes, fiscal drag or conjuring tricks with diverging inflation measures.
Inflation allows governments and enterprises to cheat, and particularly to cheat the least numerate and most vulnerable members of society. It makes the entire capitalist system less transparent and more open to exploitation.
Unsurprisingly voters all over the world do not like inflation. It undermines their trust in the entire capitalist system. The explosion in demand for crypto-currencies and gold is a direct reaction to governments not giving people the monetary security they want.
And by obfuscating things, inflation hides important signals. If real wages are not rising, it is important we realise that quickly and fix the causes. If taxes are no longer sufficient to meet spending, that needs to be clear. Keynes called it ‘Euthanasia of the rentier’, but perhaps boiling frog syndrome is a better analogy.
Because of the economic advantages of zero inflation, you need a high bar to justify a different target. Unfortunately the current fad of +2% does not stand up to scrutiny.
The rationale for 2% specifically is derived from a sketchy 1966 article in The Statist Magazine and the experience of New Zealand. That’s a sample size of one tiny economy. More importantly, this was a period of economic recovery for New Zealand, when the country implemented a suite of economic reforms. To say that it was all down to the 2% target is confusing cause and effect.
But why accept long-term inflation at all?
Central banks thinking stems from Keynesian economics. Keynes developed his monetary theories in the shadow of the Great Depression, during which there were periods of deflation.
Unsurprisingly, Keynes concluded that deflation was the demon, and that deflation was downward sticky – once it took hold it could not be stopped. Today’s Central banks have swallowed that orthodoxy hook line and sinker. Hence they want a positive inflation target to keep a clear cushion between them and the deflationary bogeyman.
Subsequently, and contrary to Keynes, world history has shown that inflation is far more upward sticky than deflation is downward sticky. It is easy to name fifty countries that have had inflationary spirals. I cannot name one that has got stuck with deflation. Sterling lost 98% of its value during the 20th century.
In practice fiscal and monetary policy are far more effective at controlling deflation than controlling inflation. Even since Central Bank independence, inflationary deviations to the upside have been larger than to the downside.
In other words, inflation is the real bogeyman for price stability. What central banks really need is a cushion against inflation rather than deflation.
In his analysis of the Great Depression, Keynes may also have been confusing cause and effect. The great depression (and its deflation) was the result of an unsustainable boom driven by a decade of household credit growth and asset price bubbles. Had the Fed adopted tighter money during the Roaring 20’s, then the financial bubble would have been smaller and so would the bust. Hidden behind Keynes’ theories lies the perennial lesson for central banks: Prevention is better than cure.
Of course, a rolling target of zero inflation would mean tighter money. On recent experience most of us would welcome this. The prolonged period of ultra-loose money has created far more problems than it has solved; including excessive debt, rising inequality, misallocation of capital, government waste, moral hazard and asset price bubbles.
In a damning report, The House of Lords Economic Affairs Committee has called this ‘A Dangerous Addiction.’ One that has allowed structural problems to be swept under the carpet rather than confronted. Few of us have ended up wealthier or happier as a result.
A strict zero inflation target could prevent a recurrence. And if combined with a zero bound interest rate, we could never again suffer the scourge of prolonged negative real interest rates.
In summary, current central bank mandates are based on a cursory and flawed understanding of economic history. It is thus unsurprising that they are unravelling. A stringently enforced rolling target of zero inflation would deliver more transparency, stability and growth. Prime Minister Truss should go for it.