About this time of year the world’s central bankers converge on Jackson Hole, Wyoming for a conference. This is an opportunity for many to think about what this important set of government officials should be doing. To judge by the coverage in the Economist, one of the main topics is whether the developed world’s leading central banks should raise their inflation targets, from, say, 2% to 4%. The Economist thinks they should. I am sceptical.
Monetary policy, and in particular the manipulation of interest rates, has a special place in the neo-Keynesian conventional wisdom that became mainstream in government circles from the 1990s through to about 2007, when things started to go badly wrong. The idea was that economies are best regulated at the macro level through interest rate policy, alongside “automatic stabilisers” in fiscal policy; this replaced an approach centred on fiscal policy alone that fell apart in the 1970s. Essentially central banks cut interest rates when the economy needs a lift, and raise them when it needs cooling down. The way this is managed is in relation to an inflation target, typically of 2%. If inflation dropped much below the target, it was time for a lift, if it rose above, it was time to remove the punchbowl from the party, as one central banker put it. Inflation is the main way policymakers are supposed to judge whether an economy is running above or below its natural capacity, around a target rate which is supposed to be neutral.
For a decade or so this all seemed to go very well, as the leading economies experienced steady growth and low but steady inflation. Japan was the exception, as it suffered from deflation and weak economic growth – and the country’s central bankers and political leaders were much criticised as a result. It was all too good to be true. After 2007 all the leading countries looked like Japan, and proved unable to use monetary policy to give their economies the lift they generally thought was needed. Central bankers had to deal with low inflation and near zero interest rates, meaning that they could not use interest rate policy to achieve stimulus – since they could not reduce rates below zero (a boundary that some have tried testing more recently, with mixed results). They resorted to buying bonds instead (which they called “Quantitative Easing”). Amongst other problems with this policy, it threatened to blur the line between central banking an ordinary government treasury management. There remains little sign of a serious breakout from the lacklustre post-crash economics.
Hence the idea of raising the inflation rate target. The theory behind this is that it would allow central bankers to put more oomph into their monetary easing , once they have found a way to raise inflation up to the target. The advantage of a higher rate of inflation is that it becomes much easier for central banks to implement a negative real interest rate, should that be warranted. If inflation rates are 4%, and interest rates zero, the thinking is, people and businesses will rush out to buy things rather than watch their monetary assets shrink. That then corrects the imbalance savings and investment that they think is dragging economies down.
This idea is unlikely to get very far. The first reason, and probably the most important, is that allowing inflation to rise breaches what many see as a sacred bond of trust between a government and its people. This is something that liberal economists struggle to understand. To them money is just another tool to be used in the process of managing an economy; a means to an end. But many others have a different view – a theme explored by Lionel Shriver’s recent novel, the Mandibles. This sacred bond view is why linking currency to gold is so persistently popular. And it has particular strength in the US and Germany, in spite their very different histories. Using inflation as a state policy is abuse of power in this way of seeing things. At the very least it needs a democratic mandate.
This is no small political obstacle, though I personally incline the liberal economist view, and feel that gold used as money is an outright evil. But I am sceptical that inflation works in the way it used to in the world’s leading, developed and globalised economies. Raising the central bank target is one thing, but persuading the rate of inflation to follow in an economically constructive way is another (it doesn’t help if consumer prices race ahead at 4% while wages are stuck at zero).
What’s the problem? I think global markets for goods and capital have become so integrated that efforts to raise inflation are rapidly undermined. Furthermore wages and prices seem to be driven by different forces. Public expectations of inflation, the critical driver of inflation in the neo-Keynesian model, have lost their force. The idea that there is a universal rate of inflation reflecting the depreciation of money is an idea that is becoming distinctly unhelpful. Inflation, for example, does not make private debt more affordable if it does not feed through to pay (quite the opposite, in fact); and something similar happens to public debt, as tax revenues are more likely to be driven by pay than the prices of goods and services. This is a problem that does not seem to occur to many commentators on economics.
A further problem is how low interest rates or QE transmit themselves to raised prices anyway. The old idea of expectations being managed by the government and the central bank has signally failed in Japan, for example, when Shinzo Abe’s government tried to do just that. Companies did not want to raise pay unless they really had to, and would not raise prices of goods either. It is true that a loose monetary policy can cause the currency to fall and raise import prices – but this does not necessarily transmit to the rest of the economy. In Japan it took much bullying by the government of big businesses to have any effect, and their response was so grudging that no lasting change was made. Other governments and central banks may have even less power. Imagine how German firms would respond to the ECB saying they wanted a bit of extra inflation?
So what does a looser monetary policy achieve? First there seems to be a lot of idle cash. Money that hangs around unused does not stimulate anything. And then the prices of some assets may be raised, both at home and in wider capital markets, which the globally liberated world has made very easy, without the creation of new assets. In other words, asset price bubbles start to inflate.
In short the conventional neo-Keynesian theory should be given a decent burial for the leading developed economies. It is a bit different in less globally integrated countries, or in developing countries that are subject to rising in productivity where we can expect pay to be more buoyant.
Instead of chasing this particular phantom, economists and policymakers need to ask themselves more searching questions. Why is the rate of investment so sluggish, and unable to keep up with savings? Why is conventionally measured productivity stagnant? This is the real problem. And what if low investment and low growth are facts of life in a mature economic system, rather than ills to be cured? And meanwhile we economic chatterers might ponder the role that the constancy of money plays in the social contract, and how, perhaps, we take a bit too lightly sometimes.