By Richard Robb
What should investors in developed countries worry about — inflation or deflation? Evidence from the past two decades suggests the answer is “neither.” Progress in monetary policy may have rid the world of price instability once and for all; like smallpox, Germany military aggression or the spread of orthodox Marxism, inflation could well turn out to be last century’s problem.
As recently as the 1990s, France, UK and Italy pegged exchange rates. The US and UK targeted money supply in the late 1970s and early 1980s, while the Bundesbank targeted Germany’s money supply right up until monetary union.
But in the past 15 years, leading central banks have converged on a common model to:
- set a clear inflation target, ordinarily 2 per cent per annum over the medium term
- establish a monetary policy committee independent from political pressures, meeting on a published schedule
- affirm the singular commitment to price stability at every opportunity
- express credit conditions in terms of a steady short-term money market rate
- provide transparency by issuing press releases and detailed minutes of the monetary policy meetings
Source: National Statistics Agencies
As the graph illustrates, so far, so good. Even Japan’s infamous deflation was not as severe as many people think: with the exception of 2009 when prices dropped by 1.4 per cent, deflation never reached 1 per cent in any calendar year.
The demand for money is not stable — with credit cards, automated payments and deregulation, we can no longer model money demand in terms of trips to the bank to withdraw cash. Yet nothing can undermine the eternal truth that inflation is always and everywhere a monetary phenomenon. The economies of the US, UK and the eurozone have absorbed quantitative easing without causing inflation, as an increase in money demand offsets supply. At the first hint of inflation, the central banks will have to contract. Central bankers are showing that they can stay nimble enough to manage the “long and variable lags” with which money affects prices, anchoring both inflation and inflationary expectations.
The Federal Reserve Act instructs the US Federal Reserve to pursue “three goals of maximum employment, stable prices, and moderate long-term interest rates,” but the Fed has consistently subordinated the other two goals to stable prices. As Fed governors have said many times, their only enduring contribution to employment or low interest rates is price stability. So as a practical matter, the Fed, too, targets inflation, and its target is essentially the same 2 per cent as its European and Asian counterparts.
Central banks even compete with one another to affirm their commitment to price stability in the plainest possible language. Here are a few examples from banks’ websites:
“The primary objective of the ECB’s monetary policy is to maintain price stability.”
“What We Do : The Bank [of England] sets interest rates to keep inflation low, issues banknotes and works to maintain a stable financial system.”
“The Bank of Japan, as the central bank of Japan, decides and implements monetary policy with the aim of maintaining price stability.”
Sweden's Riksbank
My favourite is Sweden’s Riksbank which illustrates its goal with a visual aid:
“The Riksbank’s target is to maintain inflation at a rate of 2 per cent when measured by CPI.”
But the winner of the contest for the simplest statement of purpose may be South Korea. It only adopted the modern approach to monetary policy in 2008, but did so with enthusiasm. The main page of its website shows a picture of the bank’s headquarters and declares “The Bank of Korea Pursues Price Stability.” “Pursues Price Stability” is in an extra-large font.
Despite their talk about price stability, the US or eurozone countries could deliberately raise their inflation targets to reduce the real burden of their growing national debts. Taking the US as an example, a simple calculation shows that neither the politics nor the economics of doing that would add up.
Assume 70 per cent debt to US gross domestic product at the end of 2011 and consider the effect of raising the annual inflation target by from 2 per cent to 7 per cent for three years. About 7 per cent of the US marketable debt is inflation-adjusted TIPS, so inflation is no help there. Neither does it help for the 22 per cent of the marketable debt in Treasury Bills, since higher inflation will translate at least one-for-one to higher interest rates. That leaves bonds and notes, all of which are fixed rate. For simplicity, assume all notes and bonds mature in more than three years. Then 15 per cent inflation over three years would knock about 15 per cent × 71 per cent ≈ 10 per cent off the real debt burden, taking the ratio from about 70 per cent to 63 per cent. The dollar value of the savings is about $700bn.
But this calculation overstates the effect since it ignores the cost from higher inflationary expectations when the experiment ends. If we assume that the Treasury refinances half the outstanding debt at a 3 per cent higher real interest rate with an average maturity of five years, the savings from inflation falls in half to about $350bn.
The social costs of 7 per cent inflation for three years do not come close to justifying a 3 per cent to 4 per cent reduction in the ratio of debt to GDP. About half of the reduction in the real value of the debt would be borne by American investors and the other half by overseas investors.
The case for monetising sovereign debt seems even more far-fetched for the eurozone. The Maastricht Treaty codifies the ECB’s independence and its focus on price stability. Much of European sovereign debt is floating rate or swapped into floating, so the gains from higher inflation are lost by the rise in nominal rates. Even if the relatively profligate countries in southern Europe determined that inflation was the most expedient way to control their debt, it is impossible to imagine how they would convince Germany and France to cooperate.
It’s a sucker’s game to predict the end of anything, from history to the business cycle to the end of the world. But if the pattern in the graph lasts another 10-20 years, the hypothesis that inflation stability is here to stay will look increasingly mainstream.
If you want to worry about something, I can recommend the US current account deficit. By continuing to run deficits equal to 5 per cent of GDP as the US has averaged over the past six years, in a generation it would transfer assets to foreigners that are equivalent to its entire stock market. A modest depreciation in the US dollar would only be enough to stimulate a J-curve making imports more expensive and having little effect on the deficit. The magnitude of the adjustment is likely to be far more disruptive than what little overall price instability seems to be in store.
Richard Robb is chief executive of Christofferson, Robb & Co., the investment management firm, and professor of professional practice of international finance at Columbia’s School of International and Public Affairs.
