IS RAISING INFLATION A CURE FOR THE ECONOMY’S ILLS? NO, THAT’S BAD ECONOMICS AND BAD POLICY, AS HAS BEEN SHOWN OVER AND OVER AGAIN. LET’S NOT MAKE THE SAME MISTAKE AGAIN.
Many of us have seen this failed strategy before
It would appear humanity is doomed to repeat the same errors every 30 or 40 years, not because people do not learn from their mistakes but because those who do grow old and die, giving way to a generation with no memory of what they endured.
There are exceptions. The response to the financial crisis, when policy-makers flooded their economies with money while keeping trade open — in contrast to the disastrous policies pursued in the 1930s — is an encouraging counter-example.
But we should remember that the success of monetary policy, then and since, was achieved in the face of a quite hysterical insistence in certain quarters that central banks had “run out of bullets” — that only fiscal policy could save us now.
Recall the enormous fuss at interest rates having hit the “zero lower bound,” which turned out not only to be no hindrance to effective policy — central banks switched from fiddling with interest rates to direct purchases of government bonds, so-called “quantitative easing” — but not even the lower bound: interest rates in a number of countries have since descended into negative territory.
Nevertheless, inflation has lately been lower than central banks have intended, while economic growth has been slower than governments would like. And so a new wave of analysis has attempted to draw a connection between the two. Maybe growth is slow because inflation is low. Maybe the ticket to faster growth is a little more inflation. With the Bank of Canada’s current inflation target of two per cent (plus or minus one percentage point) up for renegotiation later this year, some are calling for it to be raised to four or five per cent — or even abandoned altogether.
I say “new wave” with a roll of the eyes, because we have been here before. People thought a little more inflation was just the thing to spur growth in the 1960s and 1970s. After all, there did seem to be a relationship between the two: you could plot it on a graph, called the Phillips Curve after the engineer who first noticed it. But it turned out that, indeed, correlation was not causation. Repeated doses of higher inflation did not result in faster growth or lower unemployment, or not beyond the very short term. All you were left with in the end was higher inflation: not the “little more” first proposed, but a lot more.
Nevertheless, here we are again, memories of the Great Inflation — and the painful, decade-long withdrawal from it that followed — having faded, and a little more inflation is again being touted as the cure for the economy’s ills. For some, it is enough that growth, at two to three per cent annually (real, i.e., after inflation), is slower than the four per cent they think appropriate. Others are more concerned with what will happen in the next recession.
With inflation and shortterm interest rates both at one per cent or less, they ask, how will central banks be able to engineer the kind of deep rate cuts that might be needed to jolt the economy back to life? Push inflation up to, say, four per cent, on the other hand, with interest rate increases to match, and central banks would have more room to cut rates in a crunch. At any interest rate below inflation, you’d in effect be paying people to borrow.
There are variants. Some argue that central banks, rather than target inflation, should aim to hit a certain growth rate of nominal GDP — what you get when you add real growth and inflation. When growth was low, inflation would rise a few points; when growth was high, inflation would subside. But the goal is ultimately the same: to let inflation drift higher in times of slack.
There are a number of problems with this. First, it’s far from clear that what is holding the economy back has anything to do with monetary policy. Monetary policy can, with considerable uncertainty, affect the total amount of spending in the economy — that is, the demand for goods and services. But it can say nothing about the supply: the economy’s actual productive capacity.
That’s been constrained rather by such things as a declining workforce, with the first wave of baby boomers hitting retirement age; the continuing fallout from the oil price collapse; and sluggish productivity growth, a long-standing problem with many causes, none of them monetary.
Efforts to cut real interest rates by raising inflation are unlikely to prove more successful now than in the 1970s, and for the same reason: they depend upon people not noticing what is going on. Even if you could hold short-term rates down, long-term rates would surely rise to compensate for the expected higher inflation. Worse, so, before long, would wages. Once inflation expectations take root, they’re very hard to dig out.
It would seem contradictory, last, to argue that the same central banks that have been unable to hit a two per cent inflation target can be relied upon to manoeuvre it up to four per cent — and having done so, keep it there, rather than let it rise to six or eight or 10 per cent. Me, I’ve seen this movie before. I’ve no wish to see it again.
Canada was a pioneer in inflation targeting, and it has served us well. Messing with it seems a needless risk, especially for such an uncertain payoff.
IT’S FAR FROM CLEAR THAT WHAT IS HOLDING THE ECONOMY BACK HAS ANYTHING TO DO WITH MONETARY POLICY. — COLUMNIST ANDREW COYNE