In central bank lingo, price stability somewhat preposterously means an engineered, predictable and stable increase in the price level. Most central banks, including the Fed, the Bank of England, the Bank of Japan and the European Central Bank, define price stability as a year-on-year increase in the consumer price index of 2% and the aim of monetary policy is to maintain inflation close to, but below, this target. The 2% target has proven popular because it is seen as low enough to avoid the risk of accelerating inflation and high enough to prevent small negative shocks form causing deflation – the great evil in the minds of central bankers. Conventional wisdom has it that deflation makes consumers hold on to their cash in expectation of increased purchasing power in the future – thus slowing economic growth, which Keynesians believe spring from consumption. Central banks also fear deflation because their primary tool of interest rate manipulation has no limit to the upside but is restricted by the zero bound on the downside – that was at least the thinking until the Global Financial Crisis, after which Japan has adopted negative policy rates and the ECB’s QE programme has resulted in negative yields on especially German government bonds.
The neo-Keynesian school that dominates central bank thinking tend to regard inflation as a trade-off versus unemployment, crudely captured in the so-called Phillips Curve. The belief in the Philips curve has faded over the years, as empirical evidence has failed to support the theory – with periods of high unemployment and low inflation and vice versa. Still, most central bankers have faith in the notion that if employment can be maintained at a certain (natural) rate, inflation can be kept stable – though the curve shifts over time, as first pointed out by Milton Friedman. This is the so-called Non-Accelerating Inflation Rate of Unemployment (NAIRU). If employment deviates from the NAIRU, central bankers can fine-tune by manipulating the money supply, either directly via purchasing securities for newly printed money (so-called Open market Operations) or indirectly via fixing short-term interest rates. By these crude levers, central banks can control economic growth to deliver optimal prosperity while keeping the inflation genie in the bottle. This has become an almost universally unquestioned dogma but is actually counter-intuitive: strong economic growth means more production and should mean falling prices as the means of exchange chase the increase in produced goods. What actually causes inflation is of course the continuous increase in the money supply. In fact, in the Austrian school of economics inflation is defined solely as the increase in the money supply without considering the price level. In a growing economy, prices should be falling and it is not enough to observe the price level in order to identify inflation.
What central bankers and mainstream economists misunderstand is that money is not neutral. Money neutrality supposes that changes in the money stock affects only nominal variables (wages and prices) and has no effect on the real economy. This is supposed to hold in the medium to long term if not in the short term. But an increase in the money supply is not a instant shock but diffuses over time through the economy. Those who first receive the increased monetary base will be able transact at the existing price level, but as the increase in the monetary base diffuses throughout the economy, prices rise and latter receivers faces increasing prices. This is what is known as the Cantillon effect and implies that an increase in the price level is not homogeneous across assets and price.
This implies a fundamental problem with the current central bank paradigm. The choice of inflation targeting assumes that price stability, and hence the absence of (too much) inflation, can be captured in the consumer price index. After the Global Financial Crisis, consumer prices have indeed been stable and central banks have been able to pursue their mandate while keeping interest rates at unprecedented low levels. But outside consumer goods, prices have not been stable. Equity markets, emerging markets, bond markets, housing markets have all enjoyed record growth rates. Yet most central bankers seem unconcerned. We have seen this complacency before: in America’s Great Depression, Murray Rothbard wrote: ‘More and more economists came to consider a stable price level as the major goal of monetary policy. The fact that general prices were more or less stable during the 1920’s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware’.
The parallels to the current situation are obvious. Rates have been far too low for far too long. While bubbles are there for all to see, if only they bother to look, central banks are seemingly unconcerned, because inflation has not yet shoved up in the only index they care about; consumer prices. For those of us who follow Austrian economics, the next crash will come as no surprise. The central bankers and all those who continue to trust the existing paradigm will once again be caught unawares.