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Henry Thornton - Economics: A discussion of economic, social and political issues Monetary policy and asset inflation Date 06/10/2009
Member rating 4.5/5
Henry proposes a new target for monetary policy - True Inflation.
By Henry Thornton Email / Print

Markets expect either one 50 basis point hike or two 25 basis point hikes before Christmas.

I am not so sure that the Australian economy is as strong as suggested in recent speeches by Glenn Stevens and his colleagues, but I naturally defer to them as it is their full-time job, aided by teams of Australia’s brightest economists.

In any case, Stevens’ stated readiness to get on with the task of adjusting monetary policy from current ‘emergency’ settings accords with my consistent advice to avoid tightening monetary too little too late during booms.

I interpret the speed and size of the rate cuts from October last year as showing a new predilection for decisive monetary policy action.  But it is now, during the recovery, that we shall discover if there has been a highly desirable move toward more decisive action in recovery as well as scary downturns.

But there is another issue for monetary policy – what is the most appropriate indicator of inflation?  I infer from his speeches that Glenn Stevens, like many other central bankers, now believes that asset inflation (or deflation) should be part of the considerations when deciding on whether to tighten or ease monetary policy.  There is a very obvious reason for this change of focus.

This is that lack of decisive monetary policy action in the last boom was partly due to the fact that subdued goods and services inflation was the guide to policy and asset inflation was virtually ignored.  Goods and services inflation was held down by the growing influence of China and India as suppliers of cheap manufactured goods, but excess money spilled over into asset inflation.  Banks began to lend freely on the basis of rising asset values, borrowers purchased assets as well as goods and services, eventually producing self-reinforcing asset bubbles. In the leading edge economies like that of the USA, this process was assisted by innovative packaging of loans that were on sold to who knows who in a furious chase for ever bigger bonuses by the bankers concerned.

Henry reads the golden legion of central bankers as accepting much of this logic, but hung up on what to do about it.  I have a modest suggestion, which if past form is repeated will be ignored, then scorned until finally we will be told this was the approach of the central bank all along.

With the assistance of Julian McCrann of Roy Morgan Research, I have constructed a series called with deliberate provocation ‘True Inflation’. It is a weighted average of four series – underlying CPI inflation (the Reserve Bank’s current main guide to action), consumer inflationary expectations (in deference to the regular central banker talk of the need to ‘anchor’ such expectations), house price inflation (representing Australia’s favourite asset class) and share price inflation (Australia’s second favourite asset class).

Weights are equal, and it is a job for central bank researchers to decide if better weights might be devised or indeed if other asset classes might be included – tulips in Holland, perhaps, South Sea Corporation stocks in the UK, Internet stocks in the USA, fine art everywhere.  (With this matter settled, a target range would need to be devised, but that is a topic for another day.)

True inflation is the solid blue line on the graph.  The dotted line is underlying CPI inflation which as noted is the current ‘official’ indicator of inflation in Australia.  The red line shows the cash rate.  Solid data for all series only goes back to 1987, although share price data is available for a far longer time. 

No doubt a longer series of house price data also can be found if the spirit is willing.

For much of the period since the late 1990s, True Inflation and Underlying CPI inflation showed reasonable similarity of movement – both rising with True Inflation rising faster on average but with greater volatility.  But at the end of the recent boom there was a major divergence.  Asset prices – especially share prices – and cash rates also fell sharply, although with a distinct lag. 

Now we all know that correlation does not mean causation.  Someone wishing to criticise Henry’s line of thinking might say that the share market crash was a symptom of the general economic panic and it was the latter fact that led the Reserve Bank to cut interest rates so sharply.  A defender of using share price data as a guide to monetary policy action might say that share prices anticipate economic fluctuations, but either answer leads one back to the discredited ‘check list’ and most people (not Henry!) would say that way lies madness.

Henry’s current thinking relies far more on economic theory.  The logic is seen most clearly in a series of simple propositions.
1. Inflation is always and everywhere a monetary phenomenon. (Friedman)
2. In normal circumstances asset prices and goods and services prices will move in similar ways, and simple rules for monetary policy will produce reasonable results.
3. However, in an increasingly complex world, inflation of just what (and when) depends on circumstances in particular markets. (Globalisation is a massive cause of complexity even with floating exchange rates.)
4. If goods and service markets have little inflation, excess money will raise asset prices.
5. Conversely, if asset market are depressed, goods and service inflation will be where excess money shows up more quickly and more certainly.
6. If there is a general state of depression, excess money will pool more or less uselessly and monetary policy expansion will be like ‘pushing on a string’. (Keynes)

Economic theory has not yet convincingly integrated markets for goods and services and assets – with ‘money’ as a special case, as a vital part of the economic infrastructure and as a popular buffer stock for individuals and firms.

Henry is confident that when such a theory is ultimately worked out and tested, the six propositions set out above will be consequences of the theory.

Today or in early November the Reserve Bank will raise the cash rate either by 25 or 50 basis points.  Henry’s inclination would be to wait another month and then hike more boldly by 50 basis points - provided the local economic data still indicate recovery and provided there is no major global economic setback.  And provided True Inflation is still rising.

Henry Thornton's measure of "True Inflation" in the Australian economy is a weighted average of FOUR important other measures of price changes. CPI (Underlying Inflation), Australian Inflation Expectations, House Price changes and Share Price changes. To calculate Henry Thornton's "True Inflation" each Year-over-Year change (measured quarterly) in these four measures of price is multiplied by 0.25, and then the four measures are added together to produce Henry Thornton's "True Inflation."

This article published today in The Australian.

See comments here from the Business Spectator's David LLewellyn-Smith.

'Frankly, The Australian smashes the combined efforts of the three Fairfax papers. Rather than state the obvious on interest rates, The Australian’s Henry Thornton thinks his way through a new model for judging “true inflation” that “is a weighted average of four series – underlying CPI inflation (the Reserve Bank's current main guide to action), consumer inflationary expectations (in deference to the regular central banker talk of the need to "anchor" such expectations), house price inflation (representing Australia's favourite asset class) and share price inflation (Australia's second-favourite asset class).” Bravo'.

An old friend and colleague, Professor Henryk Kierzkowski of Geneva, sent a link to an article published in May by Lord Saatchi - 'Blame this crisis on the myth of inflation'.

Subject: possible factors
Posted by: Cameron
Date: 6/10/2009
just thought i might suggest also factoring in returns such as index p/e's to apply inverse weight in rate calculations.
Subject: Monetary Policy Targets
Posted by: Philip
Date: 12/10/2009
Why wouldn't the level of private debt be the one crucial indicator in addition to CPI, that could be included in monetary policy targets?
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