‘Everyone’ it seems is worried about inflation. Today I’d like to introduce you to a draft chapter of a book written by Pete Jonson, founder and frequent contributor to Henrythornton.com. A major problem is that inflation is very damaging but now, after nearly 30 years, there are cries of ‘inflation is too low’. That is goods and services inflation, gentle readers, but what about asset inflation?
This blog presents the second half of Jonson’s draft chapter ‘The Scourge of Inflation’.
Why has inflation been so low?
Still on the question of commodity inflation, is it just the ‘Accord’ between the RBA and the government that been so apparently successful? A major point is that low inflation has been a widespread global result, and not all central banks can claim such an accord. In particular, the US Fed operated under the same rules after 1996 as before it.
The first low inflation cause is the rise of China, India and the manufacturing powerhouses of South East Asia, which established ‘low inflation’ as a vital part of the thinking of the global workforce. This set up a low inflation loop that left both wages and commodity inflation growing slowly.
The second is Paul Volcker’s new rules of play in US monetary policy. After two recessions in quick succession in the early 1980s, US commodity inflation was driven down and has stayed down since. Mr Volcker is a large man with strong ideas and that made many Americans take his words to mean what they said. Together with the Asian industrial breakout this provided low inflation expectations everywhere except in some crazy banana republics.
The third is the global financial crisis of 2007-08. With banks failing, real estate prices in America plunging and American industry taking a belting, and similar things in other developed nations, business and household inflation expectations, already low, stayed low.
It is far too early to test these hypotheses in any scientifically respectable way. I believe these points will eventually come to be the agreed reason for commodity inflation to remain low from the early 1980s in the USA, and about a decade later elsewhere, as in Australia.
As part of the response to the global crisis, central banks slashed cash rates of interest and embarked on so-called ‘Quantitative easing’. The latter policy exchanged private sector bonds for cash, the theory being that this was the way to supercharge monetary policy. Together with bail-outs and fiscal expansion, this policy prevented the deep recession or even depression many feared when the western economies began to crumble.
What about asset inflation?
This is a question that has confused many fine economists. I have reported the alleged comment from two RBA governors that ‘We have no framework’ for this. Current governor Philip Lowe during his time in the American academic world wrote in an article for the Bank for International Settlements (BIS) with Claudio Borio, wrote that if asset prices are rising too quickly it is appropriate to raise interest rates.
It is worth quoting the abstract in full. 'This paper argues that financial imbalances can build up in a low inflation environment and that in some circumstances it is appropriate for policy to respond to contain these imbalances. While identifying financial imbalances ex ante can be difficult, this paper presents empirical evidence that it is not impossible. In particular, sustained rapid credit growth combined with large increases in asset prices appears to increase the probability of an episode of financial instability. The paper also argues that while low and stable inflation promotes financial stability, it also increases the likelihood that excess demand pressures show up first in credit aggregates and asset prices, rather than in goods and services prices. Accordingly, in some situations, a monetary response to credit and asset markets may be appropriate to preserve both financial and monetary stability.'
[Reference: Claudio Borio and Philip Lowe, 'Asset prices, financial and monetary stability: exploring the nexus', BIS Working paper, No 114. Paper presented in 2005, this version published in 2005.]
Despite this powerful statement by two fine economists, it is interesting that Dr Lowe did not raise interest rates during Australia’s massive housing boom. Now that house prices are falling, the Reserve Bank is letting it be known that interest rates are likely to be cut, even lower than the record levels of cash rates at 1.5 %.
My own research, to be discussed later, shows that asset inflation mostly moves more or less in the same direction as commodity inflation, which perhaps provides support for Dr Lowe’s statement quoted above. For the US economy, with two colleagues I updated the work of Friedman and Schwartz. Firstly adding 52 years of data and allowing for asset inflation, represented by US share inflation. Mostly commodity inflation moves in the same direction as monetary policy, as does share inflation. But there are several ‘aberrant periods’ in which share inflation moves very differently to commodity inflation. More on this later.
[Reference: Peter Jonson, Libby Prior Jonson and Ka Mun Ho, 'Updating Friedman', Unpublished paper available on request, 2013.]
Yet monetary policy is not the only effect on either type of inflation. In particular, asset inflation is also strongly influenced by ‘Animal Spirits’. While commodity inflation is strongly influenced by monetary policy it is also influenced by labor costs and the state of the labor market. The ‘extraneous factor’ for the two types of inflation is very different so in dynamic but slowly adjusting economies both types of inflation will behave differently at times.
[Reference: Peter Jonson and Clifford Wymer, 'A macro-economic policy model of the United Kingdom 1855 - 2014 with investment, share prices and “Animal Spirits”, Paper presented at Conference of the Western Economic Association, Vancouver, 2018, and shortly to be presented at Cornell University.]
Clearly there are some interesting questions to be sorted out here, and the question is whether the Reserve Bank’s Research Department is doing the relevant research.
The full draft chapter may be accessed here.
Please forgive the playful title. Jonson regards the RBA as a secular monastery.
A more sober coverage is thanks to John Kehoe of the AFR.
Fiona Prior totally enjoys Dexter Fletcher’s take on the life of Elton John ‘Rocketman’. More here.