Stop targeting price stability?

Mark Carney recently gave a speech on the current situation of the UK economy and the Bank of England’s stance on rate hikes. It is expected that a rate hike won’t be due until 2017, due to deflationary pressures (note: China and the EU).

Carney listed three development factors that will affect whether a rate rise will occur:

  • Sustained growth relative to trend. That is continuing to grow at a pace through with to eliminate the difference between the economy’s potential growth and its current growth.
  • Rising domestic cost pressures.
  • Core inflation movement towards target. The Bank of England targets 2% inflation, asymmetrically.

Why are we fixated on inflation?
Price stability is the number one raison d’être for Central Banks. It is argued that stable prices allow for stable growth. Inflation harms businesses, through increased costs, and it reduces the purchasing power of individuals. You only need to look back to hyperinflation in 1920s Germany, where money was used as kindling for fires, and buckets of cash where used to buy a loaf of bread, to see an example of inflation-induced mania. If wages don’t rise as fast as inflation standard of living drops dramatically, as goods and services become more expensive but individual income remains stable.

Falling prices… good for the consumer?
Yes and no. Sure falling prices means that goods and services are cheaper, therefore you can consume more an as individual. However the risk is you fall into a deflationary spiral. This is when consumers hold off spending, anticipating further prices falls, and therefore due to lack of demand prices fall even further. Cutting prices means less profits for businesses and therefore job losses and stagnant/declining economic growth. A particular case study for this is Japan, where the above has happened for nearly two decades, leading to Japan’s ‘lost decade’ of growth.

Is price stability even a good target?
Some critics have argued that targeting price stability doesn’t help stabilise the economy. Martin Wolf argued in the FT.com that inflation targeting simply hasn’t worked. Prices were stable pre-2007/08 and even pre-1999/00, yet we were still faced with catastrophic crashes that harmed stock markets and spilled over into the real economy. He argues that the slump we are experiencing today is worse than those created by the inflationary 1970s and disinflationary early 1980s. Taylor 2009 used his ‘taylor rule’ of an optimal monetary policy level to review the actions of the Fed in the build-up to the 2007/08 crisis. He found that rates were kept too low for too long. Central banks had been targeting price stability, but their own forecasts were not efficient in keeping prices stable and thus lead to rapid rises in interest rates in reaction to an inflation jump, which heavily contributed to the collapse of the CDO market and the financial crisis. This divergence from optimal policy is shown in the figure below.

Screen Shot 2016-01-31 at 19.26.36

Therefore, not only is it argued that price stability targets are possibly not effective but also that central banks are not efficient or credible in achieving them. However this does not mean we should give up on price stability, what the above has argued is that keeping prices stable should be part of a bigger picture in stabilising the economy. Whilst price stability is extremely important in setting expectations for individuals and the private sector, the central banks should consider using additional tools, such as regulation limits on lending for real estate, to help control for bubbles or contractions in specific areas of the market. By expanding the mandate for the central banks they could become more helpful in keeping our economy in balance.

@ProdigyMarkets

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