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.