Wednesday, March 18, 2015

Why Do Central Banks Want 2% Inflation?

It is now well known that central banks around the world including the US Fed want some inflation. Not too much inflation. But they do want some inflation. The question arises as to why they want any inflation? Mark Carney, Governor of the Bank of England, recently gave a speech where he asked and answered that very question from a Central Bankers point of view. You can read the full speech here. Below are the key quotes related to this question.


"Why do we target the low, but positive, inflation rate of 2% rather than a zero or even negative rate?

The simple answer is because it’s our job, given to us by the democratically elected representatives of the British people. We are accountable to Parliament for meeting it. On the occasions when inflation moves by more than 1 percentage point away from the target, we are required to explain publicly why that’s happened and what we’re doing about it in an open letter to the Chancellor. Before this year, that had happened 14 times in the past when inflation has been too high. 

The particularly subdued January inflation rate meant I had to write the 15th open letter, the first to address these points with respect to very low inflation. It is likely that I will have to write a few more of these over the course of the year. 

Our remit for 2% inflation reflects the lessons of the past, including the fight against high inflation in the 1970s and 1980s, as well as the deflationary disasters that have followed past financial crises.

Low, stable and predictable inflation helps to stabilise households’ and firms’ expectations about future price increases. That helps them plan their spending, investment and hiring decisions. In short, the Bank of England worries about inflation so that everyone else doesn’t have to. 

High inflation damages growth, in part, because high inflation also tends to be volatile, generating uncertainty that makes important economic decisions more difficult.

In contrast, a little inflation “greases the wheels” of the economy, helping it to absorb shocks.

One example of that is in the labour market, where workers usually resist reductions in their cash wages when economic conditions deteriorate. This behaviour can prevent the inflation adjusted value of wages from declining when demand for labour is weak, leading to unemployment. If that is the case, it may be better for the economy as a whole if firms’ real labour costs can adjust over time through increases in prices – a little inflation – instead. 

A positive average inflation rate also gives monetary policy space to respond to negative shocks by cutting interest rates. That’s because in normal times the “equilibrium” level of interest rates at which the economy would tend to settle without generating inflation reflects, broadly, the rate of underlying growth in the economy plus the inflation target. The lower is average inflation, the less scope there would be for monetary policy to reduce interest rates in response to shocks before they approach zero. Because the equilibrium rate is so central to monetary policy I will come back to discuss it further in a few moments. 

Persistently low inflation can be difficult. Deflation proper – by which I mean a persistent and generalised decline in prices – is potentially dangerous. During the Great Depression, sharp falls in prices reinforced collapsing output and skyrocketing unemployment. 

To consider how susceptible we might be to it, it is helpful to review why such deflationary spirals are potentially dangerous. 

A commonly cited reason is that falling prices prompt households and firms to delay spending and investment. The subsequent reduction in demand causes further reductions in prices through higher unemployment. That further reduces incomes and spending, drawing the economy into the vortex. The relevance of that dynamic depends on households’ willingness and ability to delay consumption. 

There are limits to the ability of households to delay consumption of some items, however, like food. And the psychology of instant gratification – the tendency for all of us to discount the future heavily relative to the present – mutes the willingness of households to wait for lower prices. It’s fair to say that thus far there’s no evidence as yet of delayed gratification taking hold in the UK.

There would be, however, a more clear and present danger arising from the balance sheets of households and firms should deflation persist. This is a concern across the advanced world, where private debt levels remain very high relative to history, including the UK.

When a household takes out a mortgage or a firm secures a loan, the amount owed is denominated in cash terms – that is, not adjusted for inflation. Unexpected, generalised, and persistently falling prices then mean the real value of debt increases: the same amount of money is owed, but that money now buys more goods and services. As a result, more consumption or investment needs to be foregone to service the debt.

This debt-deflation dynamic was at the core of the Great Depression and in the Japanese malaise following the collapse of the asset bubbles of the 1980s. It would be a particular concern if the pace of wage growth were to follow prices down. 
My added comments:

So there you have it directly from the Governor of the Bank of England. Central Banks want 2% inflation because "private debt levels remain very high relative to history" and that debt gets much harder to keep servicing without inflation to cheapen the debt. It goes without saying that governments around the world (who are gigantic debtors) need inflation for the same reason.

When all else fails, Central Banks will try to cheapen their currency to get inflation using low interest rates and easy monetary policies. This leads to the "Currency Wars" we see these days around the globe. The US Fed wants this same 2% inflation rate like everyone else. But they have not been able to get it. Raising interest rates is likely to make the problem worse and encourage deflation in the US (US dollar gets stronger instead of a little weaker). 

Why then would the Fed raise rates you ask? If they don't raise rates, the markets may think Fed policy has failed to support a real recovery (recovery can't stand on its own two feet without Fed help). If they do raise rates, they may send the economy back into recession. You see their problem. We'll see how they deal with it.

Update 1:30 pm CST: Fed issued another virtually meaningless statement (we will probably raise rates unless we don't) this afternoon. This quote from Janet Yellen tells you all you need to know about how meaningless the Fed statement was:

“Just because we removed the word patient from the statement doesn’t mean we are going to be impatient,” Chair Janet Yellen said in a press conference Wednesday in Washington.

For those who may be wondering where we stand on the road to major monetary system change, check in tomorrow for an update article on that. We'll take a look at it.

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