Tuesday, June 8, 2004

By CHRISTOPHER LINGLE

Special to The Japan Times

PARIS -- Many central bankers have been singing the praises of inflation targeting as a way to guarantee stable price levels and bring about sustained economic growth. For its part, the Bank of England helped pioneer inflation targeting and is credited with successfully holding deviations within 1 percentage point from above or below a target rate of 2.5 percent.

Support for setting inflation targets comes from a belief that, when central banks stabilize price levels, market mechanisms will operate better. Since a stable price level allows buyers and sellers to see changes in relative prices, resources can be allocated more efficiently and economic growth promoted. When increases in the price level are unexpected, it is more difficult to distinguish between relative price changes and changes in prices due to changes in the price level.

This logic suggests that increases in the price level -- if they are stable and predictable -- are acceptable. This approach to price stability does not require central banks to oversee low rates of price increases; they must ensure only that rises or falls in the general price level can be anticipated.

It is as though the negative effect of inflation can be neutralized by limiting changes in the price level so that they are both stable and predictable. A high rate of rising consumer prices that is anticipated is consistent with price stability while a persistent decline in consumer prices is OK as long as it is expected.

Even if the rate of price increases is predictable and stable, though, there will be deadweight losses to the community that take several forms.

First, consider the assertion that the logic of inflation targeting to ensure price stabilization is based on the assumption that the effect of increasing the rate of money growth on the real economy will be neutral. Since only the price level changes, putting more money in the system supposedly does not change the relative prices of goods and services.

But this is nonsense. Increasing the growth rate of the money supply also leads to changes in demand for goods and in relative prices through a dynamic process that leads to a redistribution of wealth.

As it is, the relative prices of goods and services within a market economy cannot be established independently of money. Monetary prices are determined by the demand for and supply of goods simultaneously with money demand and supply. Therefore, it is impossible for a change in money supply to be neutral on the relative prices of goods.

When new money is injected into an economy, those that receive the new funds first will benefit most from the injection since they can use the money to buy more goods while prices are unchanged. But as the new money begins to circulate more widely, the prices of goods will begin to rise. This means that those that receive the benefits from monetary injections later on will find that higher prices reduce the amount of goods they can consume.

And so, increasing the money supply causes real wealth to be redistributed away from those who are late recipients or nonrecipients of new money. Meanwhile, early recipients will enjoy an increase in their real wealth that changes their demand for goods and services while altering the relative prices of goods and services.

A second flaw in the reasoning that stable and predictable price increases have a neutral effect upon the real economy is the "bracket creep" for tax liabilities. When incomes are adjusted upward to compensate for lost purchasing power from a rising price level, individuals will be bumped up to higher marginal tax rates. It is well known that increasing marginal tax rates weaken the incentive to work and tends to reduce overall supply.

"Phantom" capital gains will only reflect rising prices rather than real scarcity. Actions to avoid the higher tax liabilities will tend to make capital flows less fluid.

And so the most obvious indictment of inflation targeting is that it fails to provide sufficient protection against asset bubbles. The massive amount of liquidity created in the 1990s affected asset markets but did not push up consumer prices in a significant manner, since global competition softened the pricing power of firms.

Unfortunately, most central bankers think of inflation in the narrow terms of rising consumer prices as measured by an arbitrary indicator like a consumer price index (CPI). But a rising CPI is just one of several possible results of rapid growth in the money supply. Asset bubbles and a depreciating currency are two others. All are a response to an inflated money supply.

Inflation targets guide central bankers in deciding how to implement monetary policy to stabilize prices rather than to minimize price rises. However, this approach introduces massive distortions into the real economy.

Policies of inflation-targeting in pursuit of price stability have brought financial instability and asset price bubbles. It would be better if central banks put tighter controls on monetary indicators such as money growth and credit growth.

Christopher Lingle is professor of economics at Universidad Francisco Marroquin in Guatemala and Global Strategist for eConoLytics.com.

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