This is a re-post of an article originally published on pundit.co.nz. It is here with permission.
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, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.
41 Comments
You'd need to qualify that statement for it to be true.
Way back in my Uni days we learnt that its was unexpected rises in inflation that did the damage. Ditto for deflation. (But how much 'damage' is actually caused by deflation is moot as we have little reliable empirical evidence for its effects.)
If wages are going up by 10% p.a. and inflation is going up by 10% p.a. ... Do you really have inflation?
The old argument that people savings are debased is nonsense if interest rates are also at 10%.
But "what about the poor beneficiaries?", I hear you cry. They're indexed nowadays. (And should be indexed to wages but alas we have yet another beneficiary bashing government and their entitlements will be linked to a lower index ... A truly bad one ... The CPI.)
If wages are going up by 10% p.a. and inflation is going up by 10% p.a. ... Do you really have inflation?
The old argument that people savings are debased is nonsense if interest rates are also at 10%.
Only if we exclude interest payments from being taxable. If I'm earning $10k gross interest on my $100k deposit, but then paying $3300 to the gubbermint my savings are definitely being eroded in a 10% CPI inflationary environment.
re ... "Most people save while they work, for retirement."
Do they? Prove it.
No "they" don't. People save, working or not, for all sorts of reasons. Paying the mortgage is prevalent one at present.
You know where Facebook is, right? Without qualification your statement has zero merit. Ergo, FB is where it should be posted.
Was the RBNZ panicking at 7.3% CPI? Didn't seem to be. What does the range even mean? Orr reduced OCR from 1.75 to 1.0 in 2019 when CPI was within the 1-3% range.
I think it would be far better to have a target and a simple PID control function to determine OCR. Or at least divide the RBNZ governors salary by 10x the difference between CPI and OCR target (up to a cap of course).
Why 2% though?
Is 2 the magic number in our digital age?
Why not 1%? Or 4%?
Btw, the standard rhetoric about why there needs to be some inflation doesn't hold water when examined carefully. We could just as easily aim for -1% or 0% or even 10%. (Albeit -1% would cause many computer systems, not to mention humans, a thrown sprocket or two.)
"Told you so" post coming. I have claimed for over 6 months on Interest, that inflation will not "settle" around the 2% mark, and that the Central Banks are going to have to accept to live with higher inflation for fear of destroying the economy. I still think that in the new economic environment, inflation target should be between 3 - 4%
Fair question Avalanche. IMO inflation being too high has little to do with monetary policy but is more a result of post lockdown supply constraint. Higher interest rates are in the process of destroying the economy and I predict a dark 2024 in NZ with steeply rising unemployment leading to a recession.
Firstly, IMO, "being right" is only important insofar that it helps us make the right decisions for the future.
OCR cuts in April - May would only happen if the NZ economy deteriorates even faster than I think. My guess, and its a best guess only is that the NZ economy will be in bad shape in April - May, but with the time it takes to produce the GDP, inflation and unemployment figures, I think we won't see a lowering of the OCR until the July - August.
I don't think a recession will by then be avoidable, I actually think NZ will already be in recession by July - August but the GDP numbers for these months will only be released end of October, which is terribly slow!
One school of thought on why central bankers appear impotent is that their governments have largely washed their hands of any inflation fighting role.
Thus 'monetary policy' is actively undermined by populists governments who refuse, as they did 20+ years ago, to pull any levers that would help reduce inflation, e.g. raise taxes, drop subsidies, cut back on wasteful spending, etc.
The new government in NZ is a classic example of exactly what is happening worldwide. For example, they are giving out tax cuts. And worse, tax cuts to the wealthier who can spend more and help inflation stay high.
When are voters going to wise up?.
have largely washed their hands of any inflation fighting role
At the same time bankers should not have given the sole power of bringing 'up' the good inflation. They tried with lowering interest rate , but knowingly or unknowingly causing huge private debt ponzi.
The RB has a mandate to achieve the 2%, and they have but 1 tool to achieve that result.
They have choices with the OCR. Stay put, Raise , or Lower, and then by how much.
Sometimes it just takes time for the OCR rate change, to impact in the market, given the propensity to lock rates for 2-3 years.
TDs thats a different story, most are for 12 months or less, thats why you can get 6.1% for 6 months now.
NO, that is common stated, but its incorrect.
The second tool is telling the govt to stop spending and stop policy that increases costs.
I got a paint quote of 12k the other day for roof to be painted on some flats, and 6k of that was scaffolding and cones.
My plumber invoiced me the other day and on his invoice was a $15 health and safety fee.
By design, unless you are well connected or get ahead our monetary system sets up inequalities for later generations during the final phases of a Fiat currency. No point in talking about going back to low inflation as the damage is done in this cycle.
From Masterclass.com. Perhaps substitute stocks for property in the last example.
Here are examples of how the Cantillon effect (Richard Castillon) impacts everyday life:
- Cost of living: The Cantillon effect has a significant impact on the cost of living. When the amount of money in the economy increases, good prices rise to reflect inflation. This creates a higher cost of living even as most salaries remain the same.
- Gold: In his original essay, An Essay on Economic Theory, economist Richard Cantillon uses gold as an example to describe his theory. If a nation discovers a new gold mine in its territory, the price of gold is not the only factor that changes. Cantillon believed the people who find the gold will spend their new money on luxuries, driving up prices for the general public. Until the new money circulates, the general population pays higher prices without having the same money access as the gold miners.
- Stock market: Private equity firms and investors can purchase shares of a stock at pre-inflation prices to then sell the same shares at inflated prices. This form of trading occurs due to the way money first enters capital markets.
You forget 2 interesting points Brian, that many economists dont mention.
1. High Interest rates - just like high oil prices - are actually Inflationary too, as they are a cost of doing business that require prices to increase, rent being just one example.
2. Inflation is of course related to shortage of supply versus demand - and Labour through Covid and through its over regulation have both increased the cost of supply and the quantity - an example is not enough people here to pick fruit or cut your hair or drive your bus.
Kicking these red communists and socialists to touch, will help gradually to fix these issues.
But the damage is done, and many 2nd and further rounds of price hikings - because they can and its in vogue, just like a housing market bubble, will continue.
Thank Labour for about 2% PA of the Inflation last half decade.
I recall a comment by a Swiss banker way back. It might have even been in the late 70s, but probably more likely the early 80s. When asked why the Swiss inflation back then was less than many other countries of a similar nature, he said "We aim for 1-2% inflation every year. This is sustainable in the longer run. When inflation becomes higher than this we are concerned about the rate of change more than the rate itself. It is this change of rate [in our case the trebling of mortgage interest rates over the past 18-20 months] which is the real problem."
In other words, he says, there is an optimum interest rate of between 1-2% which is okay over the longer term. They key is to keep it thus. When rates move around a lot, such as now, we know that things are out of control, just as they were back in the mid 1970s to mid 1980's. Why?
Because back then the globe was in a step change of leadership - from the old boys who were running things retiring but the new kids [us] weren't yet mature enough to manage the changes. And they were right. Well, the same thing is happening again. The boomers are all retiring but the Millennials & Gen Xers & Gen Yers & Zoomers etc. do not yet have the maturity to take things over safely.
A bit like passing the baton in a relay race perhaps.
There was a similar phenomenon in the 1930s.
Perhaps we are in a 40 year working lifetime cycle change?
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