Can Inflation Targets be Trusted to Moderate Growth after the Recession?

Recently central bank officials have sought to ameliorate concerns about the inflation potential of recent stimulus measures by assuring markets that they will pursue an inflation target to keep prices under control. But such claims may be specious if central bankers are set again to pursue poorly articulated policy tools and targets amidst their existing confusion about the nature of the new financial marketplace. In today’s environment, regulators can’t tell which institutions should be regulated as banks, traditional concepts of money have lost their meaning, and – indeed – concepts of inflation that led us to ignore two asset price bubbles are now being touted as somehow magically capable of leading the economy to a restrained recovery.

Much of what has caused the current crisis is the muddying of what is a regulated bank for policy purposes. As securities firms provided more and more traditional “banking” services, from managing checkable deposit accounts – albeit backed by money market securities – to granting consumer loans. It has become difficult to tell, therefore, where a highly-regulated commercial bank ends and a securities firm, investment bank, or finance company begins. That confusion led to the under-regulation of commercial banks and now the risk of over-regulation of (what remains of) the investment banking sector.

We have also known for quite some time that the nature of money has inextricably changed over the past several decades. It is no longer so easy to track changes to the monetary base as they funnel through the typical M1, M2, and subsequent components. The trouble arises because checkable deposits have grown to include not only checking and NOW accounts, but also money market and other types of securities accounts. Furthermore, electronic payments and credit cards have substantially replaced checks and even cash as means of payments so that even the predictive power of the monetary base is problematic. Those developments, in fact, are the reason why central banks worldwide have struggled with identifying suitable policy targets in recent decades, ultimately settling on inflation itself.

So now central bankers promise that the inflation measures that reported only mild price increases over the past decades and missed asset price bubbles in technology, telecommunications, and – most recently – home prices will constrain central bank decision-making to maintain a delicate balance between deflation and inflation in the midst of a financial crisis. Those inflation measures have a more than decade long reputation for omitting not only asset and house prices but also volatile foodstuffs and energy.

Such debates are not new. In 1911, when Irving Fisher, an economist, argued that policymakers should aim to stabilize a broad price index that included shares, bonds and property as well as goods and services. In November 1998, the Economist reported that Joseph Carson, an economist at Deutsche Bank in New York, constructed a similar price index for the U.S. Although shares had a weight of only 5% in the index, it surged during 1996 and 1997 at its fastest rate since the late 1980s, signaling the bubble that only recently burst.

So while it is easy for central bankers of late to say they’ll target inflation, the relevant question is: “what inflation do they plan to target?” The wrong target will simply fuel non-measured inflation and lead the economy quickly to the next bubble… and there is no evidence they have found the right one yet.

One Response to "Can Inflation Targets be Trusted to Moderate Growth after the Recession?"

  1. Simarmata   January 23, 2009 at 4:18 am

    Dear Mr Mason,I share your concern. What is now understood as money. There are many other financial instruments that replaces the function of money (namely means of exchange, store of values. Financial instruments are capable of creating monetary values without resorting to the real creation of real goods and services. This is certainly inflationary. I have since long, since the 1997 Asian Crisis, proposing the new inflation index, including the asset and property prices. The present inflation index distorts the economic situation from the investment point of view, because it is only dominated by the consumption basket of goods, while investing are mainly concerning the capital goods or financial instruments. I will just pick up one problem related to the property market.The property market inflation and then bubble prices need to be shed more lights. One of the main components of property like housing is land. Land is globally limited and it is locally bound. Its supply limit, makes it super inelastic from the global point of view. This had led Leon Walras to propose that land should be nationalized. I think the proposal was only a reflection of the facts that by letting it in the market, it will disturb the well function of the market economy. I myself do not share the whole idea of Walras, but I think there must be more appropriate regulation on these assets. Its scarcity could push the price very high, distorting the relative prices of assets and commodities. Land generate incomes which is denoted as le revenue non gagne, or the unearned income, which could be again attributed to be the pure rents. Analogically it happens in the other asset market especially in the financial markets (I do not treat it here)So the present inflation index is not appropriate to the management of inflation, let alone to the whole economy management.