Why central bankers are obsessed with inflation not breaching a certain band?

July 25th, 2010

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If you follow central bankers all over the world, you will notice that for many of them, their monetary policy (under normal economic circumstances) targets a particular rate of price inflation. In Australia, the RBA targets price inflation to be around the 2-3% band, according to their preferred measure of price inflation. In the US, the band was 1-2% (we doubt they are in the position of targeting price inflation now, given that they are now in the zone of unconventional monetary policy). It is not the same for every central bank though. For example, Singapore?s central bank, Monetary Authority of Singapore (MAS), based their monetary policy on the exchange rate.

By now, you may wonder why the RBA specifically target the band of 2-3%? Why not 4-5%? Why not 9-10%? Why not even higher so that price inflation will ?inflate? away the debt of the masses, as in the 1970s?

Around 4 months ago, Saul Eslake wrote a very insightful article (unusual for a mainstream economist),

 

These inflation targets were chosen because, when inflation is about ”2-point something”, people tend not to notice it. And when they don’t notice it, they tend not to do things to protect themselves against it that are likely to lead eventually to prices rising at a faster rate.

By contrast, when inflation is, say, 4 per cent or higher, experience amply demonstrates that people do notice it – and they start to do things to protect themselves against its adverse consequences, such as seeking higher wages, or (in the case of businesses) putting up prices in anticipation of faster increases in costs.

The inevitable result is that, sooner or later, inflation starts rising at a faster rate than 4 per cent, and the central bank is eventually obliged to raise interest rates to slow the economy sufficiently to bring inflation back down to 4 per cent again. But when it has done so (at some cost in terms of unemployment), people start doing the same things again to protect themselves against the effects of 4 per cent inflation.

In other words, a 4 per cent, or higher, inflation rate is unlikely to be sustainable in the way that a 2 or 3 per cent inflation rate has been. It is likely to result not only in inflation being more volatile, but also in economic activity being more volatile and, probably, slower on average.

You may notice that this is what we implied in an article that we wrote back in December 2008: Demand for money, inflation/deflation & its implication. Once you understand the logic, you will be able to see the application of systems thinking. In other words, once price inflation goes over a tipping point, it becomes a dynamic process whereby money supply will balloon in an ever increasing positive feedback loop, resulting in higher and higher price inflation rate, which if not arrested, becomes hyperinflation.

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  • Nyteyjny

    Good point – thank you.

  • Volatility is inherent in unstable systems. The financial system managed under a neoclassical frame work is inherently unstable. If you are adept in the financial markets this works in your favor. It does however tend to destroy the productive economy.

  • Pete

    It's quite interesting. I guess many may 'assume' that the targeted inflation figure is much more scientific, part of a larger macro-economic analysis or something like that. But it seems the reality is that inflation is allowed to be as high as the public will tolerate.

    So, if we were in a country that had much more influence on how people spent money… (a communist country perhaps), inflation levels could be much higher and not necessarily have the same effects…in theory? Or does the global economy play a part in all of this aswell?

  • DavidL

    Dear CIJ,
    It is funny, only after I thought about this article did it occur to me that it did not actually address the option of a 0% inflation rate–inflation is so baked into our consciousness as a necessary thing. Why not have stable money as a goal, after all one of the two things that make something money is that it is a “store of value.” The current currency regime has failed miserably at this for most of it's existence. A big deflation would make up for some of the inflation that has happened in the years since a loaf of bread cost a nickle. So why not have stable money?

  • Pete

    Because inflation is a hidden tax on everyone…and it is accepted by the public. To not have inflation would be to lose easy money (for the Govt/Banks)

  • pb

    Hi CIJ. I just read the article, the author describes a 'paper' published by the IMF's chief economist and 2 colleagues. Apparently these economists were saying that if cash rate targets for central banks around the world were higher at the start of the financial crises then they would have had more room to lower rates when the crises hit and therefore be in a better position to stimulate the economy before rates got to close to zero. So far I agree.

    But I do not understand the logic of their idea that if central banks have higher inflation targets that would mean they would also have higher cash rate targets.

    Isn?t it the other way around?

    If for example the RBA changed monetary policy over night so that inflation targets were say 5-6% instead of 2-3% wouldn?t it mean that the current inflation rate is too low and therefore the RBA would drop the cash rate target so as to increase inflation to its target? Long term fixed interest rates might be higher but if the overnight interest rate which banks charge each other is higher while the RBA target is lower then wouldn?t that mean that the RBA has lost control of the cash rate and therefore of inflation generally?

  • Remember, economists like the “everything else equal” clause. In a 2-D model, your reasoning is correct. But if we add in other variables, that's when it is not that simple.