Authors: Stephen D. King
In the midst of this storm, Germany and Switzerland managed to deliver relatively modest inflation rates.
While UK inflation went up into the stratosphere and US inflation headed into double digits, the Bundesbank (Germany’s central bank) and the Swiss National Bank steadfastly defended their reputations as guardians of their respective currencies.
While their joint performance was impressive by the standards of the day, their performances judged against today’s ambitions for price stability can only be described as failures.
German and Swiss inflation averaged around 5 per cent per year through the 1970s.
Today’s inflation targets allow for annual increases in a country’s or region’s price level of only around 2 per cent.
Through the 1970s as a whole, German and Swiss prices rose over 60 per cent – a very odd kind of price stability.
The German and Swiss experiences show that if other countries allow inflation to run out of control or more generally do not have a commitment to sound money, even the very best performers find the achievement of price stability too difficult.
Even if the ambition to achieve stable prices was there – a view some would debate – the ability was not.
Monetary sovereignty doesn’t simply grow on trees.
Theoretically, Germany and Switzerland might still have been able to achieve price stability had they allowed their currencies to appreciate sufficiently.
What, however, counts as sufficient?
To this day, central banks struggle with the competing claims of ‘internal’ price stability, as measured by consumer price inflation, and ‘external’ price stability, as measured by the exchange rate.
When, for example, the UK was forced out of the European exchange-rate mechanism in
1992, leading to a collapse in sterling’s value on the foreign exchanges, many commentators believed inflation would surge, emphasizing the impact on future inflation of sterling’s precipitous decline.
They were wrong, largely because the weakness of the domestic economy completely overwhelmed any exchange-rate influence on inflation.
The tension between internal and external influences on prices can lead to serious errors of judgement.
Imagine a world of just two countries, Lilliput and Blefuscu.
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At first, both countries successfully achieve price stability.
Then the powers that be in Lilliput decide to go on an extended inflationary spending spree, leading to a doubling of the money supply (schillings, say) and of the price level and, hence, a halving of the value of the schillings in people’s pockets.
The Lilliputian schilling should halve in value against the Blefuscucian lira.
The wise people of Blefuscu, however, see the lira rising in value against the schilling.
Unaware of the foolish inflationary policies being pursued by the Lilliputians, they fear a serious loss of export competitiveness.
The central bank cuts interest rates in the hope of preventing an ‘excessive’ appreciation of the exchange rate.
In doing so, domestic inflationary pressures begin to rise.
Blefuscu has inadvertently imported inflation from its neighbour.
The exchange rate is only useful as an indicator of inflationary pressures if the policymaker knows as much about inflation in other countries as he or she knows about inflation in the home economy.
Rarely does this prove to be the case.
Assessing monetary progress through the exchange rate is rather like assessing your driving speed by counting the number of cars you’re overtaking.
It’s an odd approach.
Your relative speed might result either from others driving with excessive caution or, instead, from your own unbelievable recklessness.
The obvious lesson from all this is that central banks are still largely dependent on each other’s behaviour, if only because they all
belong to a common global economic and monetary system.
Yet they do not all abide by the same rules, they do not all share the same objectives and, when it comes to political independence, some are more fortunate than others.
Price stability was enshrined in most central bank constitutions in the 1990s, a time when emerging economies were only just beginning to make their presence felt.
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At that time, economists had tremendous difficulties incorporating emerging economic developments into their world views – partly because of a dearth of reliable data – and often they didn’t even bother to try.
In the years following German reunification, for example, it was commonplace for economists merely to forecast progress in the former West Germany.
It was easier to maintain the pretence of statistical certainty than to admit to the inevitable economic ignorance associated with the joining up of the two Germanys, even though this was one of the most exciting political and economic events in decades.
I remember a colleague running through his views of the (West) German economy in 1992 to an investor in the Gulf.
After the presentation had finished, the investor sat back, lit a cigarette, and asked my colleague whether he’d heard the news.
‘What news?’
my colleague asked.
‘Have you not heard?
Two years ago, there was something called reunification.’
My colleague spluttered his excuses and left.
For central bankers in the developed world, the rise of the emerging economies did not seem crucially important, at least not at first.
The assumption was, and still is, that individual central banks enjoy sovereignty over both monetary policy and its impact on the inflation rate (in much the same way that economists happily pretended that West Germany enjoyed sovereignty from East Germany in the early 1990s).
Even among those central banks
without a formal inflation target – the best known of which is the US Federal Reserve – policymakers generally believe that price stability must be achieved before anything else.
The Federal Reserve’s own publications include the following wording:
The goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that ‘[the Fed] should seek to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates’.
Stable prices in the long run are a precondition for maximum sustainable output growth and employment as well as moderate long-term interest rates.
When prices are stable and believed likely to remain so, the prices of goods, services, materials and labor are undistorted by inflation and serve as clearer signals and guides to the efficient allocation of resources and thus contribute to higher standards of living.
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Or, for a more British flavour, the aims and objectives of UK monetary policy are set out, rather quaintly, in a letter from the Chancellor of the Exchequer to the Governor of the Bank of England.
The April 2009 version instructed the Bank to:
maintain price stability … the operational target for monetary policy remains an underlying inflation rate … of 2 per cent.
The inflation target is 2 per cent at all times: that is the rate which the Monetary Policy Committee is required to achieve and for which it is accountable … the framework is based on the recognition that the actual inflation rate will on occasions depart from its target as a result of shocks and disturbances.
Attempts to keep inflation at the inflation target in these circumstances may cause undesirable volatility in output.
But if inflation moves away from the target by more than 1 percentage point … I shall expect you to send an open letter to me … setting out … the reasons why inflation has moved away from target … the policy action which you
are taking to deal with it … [and] the period within which you expect inflation to return to the target.
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In other words, price stability is, like the UK prime minister, first among equals.
Even for those central banks with more than one economic objective, price stability is typically the most important.
The central bank’s job is thus to safeguard the value of the currency.
Price stability matters because Adam Smith’s invisible hand works best free of distortions.
But in both the American and British mandates, there is no explicit recognition that inflation is determined not just by domestic policies but also by developments elsewhere in the world, other than by reference to ‘shocks and disturbances’.
The rise of the emerging economies appears to be of no significant consequence.
Yet exchange rates, interest rates, commodity prices, manufactured-goods prices and all sorts of other prices are now increasingly under the emerging economies’ spell.
For a while, it was possible for central banks to kid themselves that their sovereignty was still intact.
From the late 1980s through to the early years of the new millennium, the developed world supposedly benefited from the ‘Great Moderation’, a process whereby inflation and interest rates gradually fell, where business cycles became less volatile and where global economic growth strengthened in relation to the 1970s and early 1980s.
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Yet this moderation was followed by possibly the worst, and certainly the most synchronized, global economic downswing since the 1930s.
If inflation was so low, why did things go so badly wrong?
Part of the explanation relates to an increased globalization of the inflation process.
For central banks, charged with the need to deliver
price stability at the national or continental level, this change has created three significant challenges.
First, inflationary surprises in either direction may have nothing to do with the amount of money swirling around an economy, or the prevailing interest rate.
The Great Moderation, for example, may have been more a result of good luck rather than inspired monetary judgement, reflecting the impact of outsourcing and off-shoring on the prices of manufactured goods.
Responding through monetary policy to these kinds of inflationary surprises may, thus,
add
to economic and financial instability.
If prices fall in relation to wages, as happened during the Moderation, why encourage even more spending by keeping interest rates low as well?
Second, changes in monetary policy in, say, the US, have an impact not just in the US but also, in particular, in emerging countries whose central banks piggyback off the Federal Reserve by linking their currencies to the US dollar.
Subsequent economic developments in the piggyback countries, in turn, may affect the US economy in unforeseen ways – through, for example, oil-price spikes.
If the Fed thinks about only the near-term domestic consequences of its monetary actions, it may ignore inflationary effects coming through the emerging nation back door.
Third, changes in domestic interest rates may shift global capital flows to a degree sufficient to alter the link between policy decisions and subsequent economic outcomes.
For example, the Bank of England’s policy of raising interest rates more or less continuously from 2003 through to 2007 triggered huge capital inflows from abroad.
These were then invested by UK financial institutions in low-quality junk bonds, helping fuel a real-estate boom.
While the inflows also pushed up the sterling exchange rate, thereby keeping a lid on inflation, the economy as a whole became increasingly unbalanced, paving the way for the credit crunch that followed later in the decade.
Policymakers in emerging economies, understandably, have chosen to make economic growth a priority.
Per-capita incomes in emerging economies are, after all, very low.
But, as emerging economies get bigger, their impact on the economies of the developed world, for good or bad, begins to increase.
This gravitational pull means that, even if price stability is actually achieved in developed nations, it may not be the guarantee of lasting economic or financial stability that policymakers hope for.
Price stability can, instead, offer false reassurance in a world of rapid economic change.
Its achievement can lead to instability elsewhere within the economic system.
There are many different ways of assessing the size of economies.
On the most conservative estimates, which merely measure the size of each economy in dollars, low- and medium-income economies (which include all the emerging markets) are, collectively, about the same size as the US economy.
If we pretend that the identical product should have the same cost across different countries and geographies (using either formal purchasing power parity calculations or
The Economist
’s Big Mac index), the emerging economies are, collectively, about twice the size of the US.
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The emerging economies have come a long way since the 1970s, a result of rapid economic growth year-in, year-out.
Yet they still have a long way to go.
Per-capita incomes are in some cases only a tiny fraction of those in the US or in the developed world more generally.
With further increases in income levels within the emerging world, the control of inflation in the developed world is likely to become increasingly complicated because the developed world will no longer have a monopoly influence over the global price level, whether for commodities, manufactured goods, workers on assembly lines, university graduates or London real estate.