Inflation and Monetary Policy

August 4, 2009

This coming Sunday will mark two years since the global financial crisis began.  One educational benefit of this trauma has been to clarify what it means for central bankers to promote price stability.  For certain central banks, such is the only macroeconomic objective of monetary policy, although even in those single-purpose frameworks, price stability can be trumped by the lender-of-last-resort mandate to ensure a functional monetary system.  Leaving that issue aside, a debate has long existed over which prices to stabilize.  The prices of goods and services have been the ones that traditionally guide central bankers, but critics have argued that financial assets, gold and other commodities, and the exchange value of the dollar must also be independent variables in a central bank’s reaction function. While Chairman of the Fed and afterward in his memoirs, Alan Greenspan defended a policy that did not respond directly to these other factors, arguing that asset bubbles are apparent only afterward and that the appropriate way to incorporate asset bubbles into policymaking is for central banks to counter collateral effects on real aggregate demand and goods and service prices when asset bubbles implode.

The 2007-9 experience demonstrates that the outlook for goods and service prices can not be properly assessed by monetary officials unless they explicitly factor in what is happening to asset prices.  For a whole year following the August 2007 onset of the global financial crisis, goods and service price inflation accelerated, led by commodity market strains. Consumer price inflation peaked in July 2008 at 4.8% in the 30-nation OECD, 5.6% in the United States, 4.0% in the euro area, and 2.3% in Japan.  CPI inflation crested in Canada at 3.5% in August 2008 and in Great Britain at 5.2% in September 2008.  Central bankers in the spring of 2008 were torn between whether to react to the mounting likelihood of a global recession or to accelerating inflation.  In virtually all cases, officials deferred to the latter.  The buzz word a year ago was stagflation, and the presumed lesson for policymakers from the 1970’s was that inflation must be put out first and sustainable growth restored later.

  • After cutting the Fed funds rate by a smaller 25 basis points on April 30, 2008, the Fed did not reduce its benchmark again during the ensuing five-plus months until October 8.
  • After implementing three 25-basis point cuts in alternate months to April 2008, the Bank of England left its Bank rate at the excessive 5.0% level until October 8.
  • The Bank of Japan delayed any rate reduction until October 31, 2008.
  • The European Central Bank implemented a final rate hike in July 2008 and did not commence easing until joining other central banks on October 8.
  • The Bank of Canada had cut its target from a  peak of 4.5% to 3.0% in four steps between December 2007 and April 2008 but then froze policy until October 8th.

It’s axiomatic that central bankers should guide policy by conditions they expect to exist 1-2 years into the future and not by the current situation.  This is true because changes in monetary policy affect economic activity and prices with long and variable lags.  However, it is also a fact that the temptation is powerful to extrapolate current conditions.  Accelerating inflation, even when caused by an oil market shock, creates concern about a stochastic jump to a higher plateau.  Price risks are said to be upwardly skewed.  Officials weight the possibility of surprisingly high future inflation above the opposite kind of outcome, and they rely on models of expected inflation that pick up the same kind of inferences from the private sector.

We now know what really happened to inflation over the ensuing twelve months after the summer of 2008, and its not at all what central bank officials had been contemplating.  CPI inflation slowed from an 11-year high of 4.8% in the OECD to a thirty-eight plus year low of minus 0.1%, from 5.6% to minus 1.4% in the United States, from 4.0% to minus 0.6% in Euroland, from 5.2% to 1.8% in the U.K. and from 3.5% to minus 0.3% in Canada.  Had central bank officials had any inkling of how sharply the drop would be in the prices they customarily watch, no dilemma would have existed over how to respond to divergent paths in growth and prices.  The stagflation itself turned out to be an illusionBut the only way officials might have sensed that paradox entailed integrating asset price developments more closely into their policy guidance system.

Nobody could have foretold just how much equity and real estate wealth would evaporate by March or how sharply world trade and GDP would contract.  The point isn’t that perfect clairvoyance must be demanded of central bankers.  It’s that a credit policy framework that essentially punts on the issue of asset price inflation excludes too large a piece of what determines future economic developments.  The global economy a year ago had more in common with the early 1930’s than the late 1970’s, so why get hung up on stagflation?  The main feature was the inability of heroic liquidity additions to restore financial market functionality and the widening spread of that dysfunctionality across regions and different classes of assets.  The transforming catalyst of the Lehman Brothers bankruptcy had not yet occurred, but the unorthodox rescue of Bear Stearns had already sent a message to expect the unexpected.  Allowing asset bubbles to fester weakens the predictability of goods and services inflation.  Even if the stability of the latter is what really counts in demand management, a policy that monitors and reacts to asset price inflation will probably improve the chances of securing the primary goal.

Copyright Larry Greenberg 2009.  All rights reserved.  No secondary distribution without express permission.



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