WHILE the world is teetering on the verge of deflation, central banks have one refrain: they will fight to prevent prices falling — they will push inflation to 2%.
This target has become something akin to a religious commandment: thou shalt ensure that prices rise at a rate of 2%. The European Central Bank (ECB) has embarked on a €1.2 trillion (£870bn) programme of quantitative easing to achieve it. The Bank of Japan says it will do “whatever it takes” to get there. And the US Federal Reserve has expanded its balance sheet by more than $4 trillion and kept interest rates near zero for almost seven years.
Given its prevalence, you might think the 2% target is one of economics’ first principles. In fact it is only 26 years old. New Zealand’s central bank was given independence in 1989 and told to set monetary policy to keep inflation between zero and 2%.
The policy succeeded. Other central banks took note and copied the inflation-targeting strategy — Canada in 1991, Sweden and the UK soon after.
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Then, in July 1996, the Federal Reserve decided to set its own inflation target. Alan Greenspan, the chairman, argued that if the aim was truly to have stable prices, that implied an inflation target close to zero.
One of the people at the meeting was not so sure. That person was a Fed governor called Janet Yellen. “Could you please put a number on that?” she said. Greenspan replied it meant zero to 1%.
Yellen countered that if inflation ended up near zero, it would be impossible to use interest rates to stimulate the economy when required: nominal rates could not fall below zero. Hence the Fed would not be able to set a negative real interest rate “on the rare occasions when required to counter a recession”.
Yellen’s pragmatic argument won the day. Greenspan summarised: “We have now all agreed on 2%.” The Fed’s inflation target was born.
In Europe, the ECB’s original target for inflation of less than 2% was close to genuine price stability. In 2003, the ECB changed its inflation target to “below but close to 2%”.
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The upshot is that the Fed, the ECB and other central banks have taken a conscious decision to sacrifice genuine price stability. They argue the sacrifice is worth making, allowing some leeway for negative real rates.
Their intentions are laudable, but there is a big problem: central banks may have set themselves a task that is ultimately impossible.
The trouble is that persist- ent inflation is up against a much stronger primordial force. Capitalism’s natural state is for prices to be steady or mildly declining. People are constantly discovering better — cheaper — ways of making and doing things.
History proves the point: between 1689 and 1912 consumer price inflation averaged 0.29% in Britain.
In truth, persistent inflation is unique to a brief period of the late 20th century, 1965-2007. But this period encompasses much of our own lifetime, so we think of it as the norm, rather than the aberration it really is.
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That persistent inflation had an obvious cause — the explosive increase in credit during the late 20th century, which itself was an aberration. Once that debt super-cycle ends, so too does persistent inflation.
Targeting lower inflation in the 1990s worked because central banks were just helping economies to move from an unnatural state — persistent inflation — towards their natural state, steady prices. It will be much harder for central banks to move economies the other way, from their natural state to an unnatural state. Witness Japan for the past 25 years, Switzerland for the past 20 years, and most other economies since 2008.
Also, all three channels through which central banks influence inflation have stopped working.
■ Credit expansion remains muted however low interest rates go because most economies are already up to their necks in debt.
■ Currency devaluation cannot work if competing economies respond in a tit-for-tat manner.
■ Inflation expectations are now completely disconnected from central bank policy or influence. After all, it is difficult to influence expectations when the credit and currency channels are no longer working.
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This is not to say that policymakers cannot create inflation. Of course they can. But a central bank cannot do it on its own. The central bank can control the narrow money supply — bank reserves — but not necessarily the broad money supply that ultimately drives final demand and inflation.
The broad money supply is dominated by loans. To expand that money supply, somebody has to borrow. So if policymakers really want to create inflation, the government has to borrow and spend money at will, with the central bank creating it.
The government has to take control of the money generation that is financing its spending. In other words, the central bank loses its independence and fiscal policy becomes ultra-loose. This could happen, but it’s highly unlikely unless there is a further severe downturn and policymakers feel forced to adopt desperate measures to cope with a desperate situation.
In this extreme eventuality, inflation would run away, rather than be a sedate 2%. But it would be really extreme — and is extremely unlikely. Hence our prediction: achieving persistent 2% inflation is mission impossible.
Dhaval Joshi is chief European investment strategist at BCA Research