Brian Easton: Does The Inflation Target Have To Shift?

There is a view that the world economy is entering a period of higher inflation and higher nominal interest rates, but who knows? Presumably New Zealand has to follow.

If you know everything about the inflation process, and are totally committed to central banks targeting inflation at 2 percent p.a., then there is no need to read this column. I am afraid its writer is not nearly as committed as you. Indeed, all this column offers is some guidance about an evolving discussion among overseas economists which is challenging past certainties.

Those certainties were that, some exceptional circumstances aside, inflation was a monetary phenomenon only, and that central banks should be able to reduce it to any desired level – usually set as consumer prices rising about 2 percent p.a. – although their actions would cause some short-term pain. The details of the analysis – some of which are often quite subtle – are rarely mentioned.

This view is summarised by Friedman’s alleged statement that ‘inflation is always and everywhere a monetary phenomenon’, which has become a mantra. What he (and his wife Rose) actually said was ‘substantial inflation is always and everywhere a monetary phenomenon.’ The Friedman analysis tells us little about what is happening when the inflation level is low – like at 2 percent p.a..

There is a concern that high inflation feeds on itself and will spiral out of control. However this seems to apply when the inflation is above 7 percent p.a. or so. The 2 to 4 range we talk about is chosen in the light of this conclusion. Zero inflation is not commonly the target because there is resistance to lowering prices in many markets. Zero inflation reduces the price flexibility necessary for a vibrant market economy. (Another concern is that the measured indexes of price changes do not align well, and that, especially in a service-dominated economy, they may not measure quality changes perfectly.)

Today, there are murmurings among some reputable economists against this conventional wisdom on the causes of and policy responses to inflation. For instance, the just published annual report of the United Nations Conference on Trade and Development said ‘central bankers should relax their 2 per cent inflation target and assume a wider stabilising role’. Of course, any single instance can be discounted as eccentric and I have yet to see a comprehensive account of the numerous, and not always well focussed, murmurings. Hence this very cautious column.

In practice what is likely to happen is that many central banks will not pursue the 2 percent p.a. target as vigorously as they have in the past. Perhaps they will tacitly think of a 3 or even 4 percent p.a. as an acceptable level, while continuing to talk up the conventional wisdom of 2 percent p.a.. One overseas commentator, the respected Gillian Tett, said ‘this strategy also smacks of burgeoning hypocrisy – and, most importantly, a whiff of impotence’.

I guess most of us can live with some hypocrisy; we have for years in many fields of public endeavour. But the ‘impotence’ signals what I have described as the ‘murmurings’. One danger of ignoring them is a lot of chest beating by central bankers and their acolyte commentariat with much pain added in the economy but without any gain.

What does this mean for New Zealand? I leave you to decide whether the Reserve Bank will line up with the burgeoning hypocrites or the impotent chest-beaters. The reality is whichever, and whatever the rhetoric, our interest rates are going to rise in the medium term if those in our major sources of overseas finance do. (There are various plausible assumptions in here, including about the exchange rate track.)

The expectation is that nominal annual interest rates will be rising by another couple of percentage points in the near future, although whether the effective inflation rate is also expected to increase by the same amount is not clear. My tendency is to assume that real interest rates are determined by factors outside a central bank’s control – even when the bank is not impotent.

I see real interest rates as reflecting growth prospects. If the world – or at least the rich economies which offer some security to investors – is entering a period of secular stagnation (another murmuring), then there are not good investment opportunities and interest rates remain low. (There is, of course, speculation on financial assets but that involves large wins offset by large losses; which side are you on?)

So, as best as I can understand, there is an expectation that nominal interest rates are going to remain high and may even increase, while prices are also going to be tracking above the 2 percent p.a. target. My guess is that real interest rates are not going to rise in the medium term.

That does not seem to be too bad a scenario, once one is not over-committed to price stability, does it? Except high nominal interest rates are tough on those who hold mortgages and cannot easily turn the offsetting rising housing capital gains into income for spending. (On the other hand, those depending on income from interest investments may seem better off, although the income tax regime claws a lot of that back.) As a consequence, the current grumpiness of mortgage holders is likely to continue.

Meanwhile the public commentary will lambast the government or the RBNZ (and usually both) for the bedding in of a higher interest-rate regime, thereby combining hypocrisy with impotence.

Brian Easton is an economist and historian from New Zealand. He was the economics columnist for the New Zealand Listener magazine for 37 years. This article was first published HERE