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Henry Thornton - Economics: A discussion of economic, social and political issues Should the Reserve drop inflation targeting? Date 25/04/2008
Member rating 4.5/5
Food price shock, the petrol shock and the housing price shock may spell the death of inflation targets.
By Henry Thornton Email / Print

Is inflation targeting dead?

Food price inflation is widespread and very likely here to stay. Petrol price inflation is widespread. And in China, goods and service inflation is rising rapidly, reversing recent deflation.

Goods and services inflation is up in almost every nation as excess money now raises goods and services price inflation rather than asset prices as it was while investor sentiment was strong.

As a result we may now be witnessing the death of inflation targeting -- the main operating procedure of leading central banks around the world, including Australia's.

For the Reserve Bank governor Glenn Stevens to keep overall inflation "mild" when important particular prices -- food, petrol, rents -- are rising sharply he must keep monetary policy firm and rely on this to force down sharply the prices of other goods and services or indeed of assets.

Owners of other goods and services, or assets, resist price falls and complain loudly to their governments. So do -- and with greater cause -- those people suffering from the direct effect of rising prices of food, petrol and housing.

All this is why Australian economic policy, and that of other inflation targeting nations, is at risk of causing an unnecessary recession. Or of abandoning inflation targeting, with all the loss of credibility that would entail. Or of explaining the suspension of inflation targeting while conditions normalise.

Rapid food price inflation has direct and immediate consequences. Many people in developing nations can no longer afford sufficient food, and will starve or become malnourished if generous aid is not quickly available. People in developed nations have their standards of living cut when the price of food rises, and this is compounded by rising petrol prices, in some nations falling house prices, or falling share prices or falling real wages, as money wage increases lag goods and services price inflation.

There is a current story that in America, Wal-Mart is rationing rice to wholesale buyers, a first for the mighty USA. Imagine the panic if food rationing becomes common in America? Imagine it anywhere, not so difficult when the evening television news show food riots and starving children in refugee camps in third world countries. To understand current events we need to delve into economic theory as well as real events.

In general, inflation is due to too much money chasing too few goods.

Nowadays inflation is a global phenomenon.

Of course, in the real world "goods" in the sense used here are not a single item. Also there are assets as well as goods (and services) to spend money on. This point has been especially important in recent years. Each country is (imperfectly) connected in many markets to other economies. The net result is that the effect of too much money can be difficult to sort out.

The prices of "goods" or "goods and services" (measured by an index such as the consumer price index) has until recently been held down by the rapid development of China, India and other "emerging nations".

There has been too much money -- essentially led by cash rates at a too low 1 per cent in the US economy, but too easy in most nations, including Australia.

However in recent years China-India-emerging nation development has held down the prices of goods and services globally so the excess money mainly forced up asset prices.

Asset prices are not just influenced by the money supply, of course. Asset prices are also influenced by the supply of, and demand for, assets and very recently asset demand has been depressed by battered investor sentiment.

Partly this is a consequence of tighter monetary policy, but readers will immediately realise that sharp rises in asset prices can "overshoot" -- indeed, economists see "overshooting" as an inherent characteristic of asset markets.

Once asset prices have "overshot", the stage is set for reversal.

We are experiencing such a reversal now, with greatly increased volatility in financial markets but net falls in asset prices.

If the price of assets plunge because sentiment about asset prices is depressed, to the extent there is excess money still in the system, goods and services inflation will rise.

Prices of individual goods, such as rice, will depend on conditions in individual markets as well as overall, global inflation.

It seems the current global shortage of grain is partly due to increased demand as developing nations get richer. But it is also due to western nation subsidies to grow crops that can be used to produce ethanol, a renewable (but very inefficient) way to produce petrol. But land used to produce fuel for vehicles is not available to grow grain for people to eat.

Drought has also reduced food production, and climate change may exacerbate this trend.

In theory, a wise and benevolent central bank can keep strict control of the money supply so that average prices do not change -- that is, inflation is zero on average.

This in practice is a far from perfect science, so mistakes occur, as occurred leading up to the current global inflation of average goods and service prices. But there is a deeper problem.

The process of inflation works less smoothly in reverse, when deflation is required. The most famous example is probably UK in the 1920s. During World War I, Britain abandoned the so-called "gold standard". Churchill (the "Chancellor" of his time) in April 1925 returned Britain to the gold standard at the pre-war value of sterling in relation to gold.

But in the meantime, many prices had risen, including in particular the prices (wages) of various classes of British Labor.

To restore full employment, wages (and many other prices) would have had to fall but these prices refused to fall, or fell only slowly. The net result was economic depression, high unemployment and many severely disadvantaged families whose bread-winners were unemployed.

Recognition of the "stickiness" of many wages and prices, especially in a downward direction, has led the economics profession to develop a bias for mild inflation. Australia's "target range" for inflation is 2-3 per cent, partly in recognition of the effect of sticky prices. (Partly it is because of the more technical matter that existing measures of goods and services inflation are believed to understate effects of improvements in the average quality of goods and services).

But the targeting of a specific, and low, inflation rate is a relatively new procedure for the Reserve Bank. In 1986 Treasury, on the advice of the Reserve Bank, abandoned the "conditional projections" for the growth of the M3 measure of the money supply. These "conditional projections" were Australia's somewhat wimpy version of Milton Friedman's "monetary targeting".

Abandoning "conditional projections" was necessary as the movement of financial assets back onto the balance sheets of the banks following deregulation of finance was artificially boosting M3 and therefore its rate of growth. Wrongly called "reintermediation", this phenomenon was correctly predicted to have a large impact. M3 growth was greatly boosted, which meant that attempts to achieve a relatively low "conditional projection" for M3 growth would have driven the economy into recession.

The best anyone could come up for going forward was to say, truthfully as it happened, that the Reserve relied on looking at all the economic and financial indicators -- the so-called "checklist". Critics, including internal critics, agreed that the checklist was no perfect or precise guide to policy. But, proponents said, it was a good basis for the judgments about monetary policy that inevitably had to be made by the governor and the board of the Reserve Bank.

This debate and its outcome, though preventing an unnecessary recession, had unhappy impacts on several careers. The old hands at the Reserve Bank pointed out that the issue was a nice illustration of "Goodhart's law". Roughly translated, this asserts that any statistical relationship relied upon for policy decisions will eventually let you down.

It is entirely possible that Goodhart's law is about to strike again, this time against the modern practice of "inflation targeting".

If current trends continue, before long Glenn Stevens will be dusting off the checklist.

Published today in The Australian.

Ed: A prominent public policy economist, Professor Ross Garnaut, responded overnight: "I thought that your article in the Oz this morning was one of the most important and also analytically sound contributions on Australian macro-economic management in recent years. These are hugely difficult times. I have not yet arrived at your position on suspension of inflation targetting, because i donít know what I would put in its place. But I agree that we face large risks in keeping the current system in place through the current commodity price extremes".

Henry wrote later (in his regular newsletter): Wayne Swan has been bravely supporting the Reserve Bank and its charter to bring inflation back into the target range.

But with powerful global food, oil and commodity inflation and the upsurge in China's inflation (removing a helpful source of strong deflation) this may be impossible to do except at great cost to the economy. ("The recession we did not have to have".)

So Henry suggests at least suspension of inflation targeting until the situation normalises.

This may well be the most important decision in the careers of Wayne Swan and RBA governor, Glenn Stevens. Also, and more importantly, crucial to the ongoing welfare of the Australian economy.

This is the implied thesis of Henry's latest, possibly most important, article. (Described as "seminal" by a very senior journalist overnight).

Severe food price inflation will damage more than the credibility of Treasurers and central bankers.

Many people in developing nations can no longer afford sufficient food, and will starve or become malnourished if generous aid is not quickly available. People in developed nations have their standards of living cut when the price of food rises, and this is compounded by rising petrol prices, in some nations falling house prices, or falling share prices or falling real wages, as money wage increases lag goods and services price inflation.

Are food wars possible? In the commercial sphere, resource wars are already with us.

BHP is seeking to acquire RIO and take-over battles are an endemic feature of the sector. A number of Chinese companies are said to have have "withdrawn foreign investment applications to buy into Australian resources companies after pressure from the Rudd Government".

The Government has in recent weeks "made it plain privately that it wants more time to consider the issue of the national interest in terms of ownership of the Australian resources industry".

And almost one month later, the Australian Financial Review published the views of Nobel Prize winning economist, Joseph Stiglitz:

'Inflation targeting a dangerous fad for central banks'.

No attribution, of course.

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