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BIS Working Papers No 205 Is Price Stability Enough? BIS Working Papers No 205 Is price stability enough? by William R White Monetary and Economic Department April 2006 Abstract No one in the industrial countries should now question the substantial economic benefits associated with reducing inflation from earlier, high levels. At the same time, history also teaches that the stability of consumer prices might not be sufficient to ensure macroeconomic stability. Past experience is replete with examples of major economic and financial crises that were not preceded by inflationary pressures. Conversely, history shows that many periods of deflation, based on rising productivity, were simultaneously characterised by rapid growth. Recent structural changes in the global economy imply that this history might have more contemporaneous relevance than is commonly thought. If so, the implication is that policies directed to the pursuit of price stability might have to be applied more flexibly and with a longer-run focus than has recently been the case. JEL Classification Numbers: E44, E50, E60 Keywords: financial stability, economic policy, price stability BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The views expressed in them are those of their authors and not necessarily the views of the BIS. Copies of publications are available from: Bank for International Settlements Press & Communications CH-4002 Basel, Switzerland E-mail: [email protected] Fax: +41 61 280 9100 and +41 61 280 8100 This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2006. All rights reserved. Brief excerpts may be reproduced or translated provided the source is cited. ISSN 1020-0959 (print) ISSN 1682-7678 (online) Contents 1. Introduction ....................................................................................................................................1 2. Deviating from price stability: have the costs been overestimated?..............................................2 3. Maintaining price stability: have the benefits been overestimated? ..............................................6 3.1 Traditional constraints: output growth and exchange rates.................................................6 3.2 New constraints: fixed capital, debt and financial stability...................................................7 Lessons from economic history ...........................................................................................7 Lessons from the history of economic thought ....................................................................8 Why history might still matter...............................................................................................9 4 Evaluating the conventional policy framework.............................................................................10 4.1 The conventional policy framework ...................................................................................10 4.2 Arguments for the status quo.............................................................................................11 4.3 Arguments for change .......................................................................................................12 Limited monetary resistance as confidence mounts..........................................................12 Asymmetric easing in the downturn...................................................................................13 Positive supply side shocks ...............................................................................................14 Cumulative effects given the conventional framework ......................................................14 5. What might an adapted policy framework look like?....................................................................15 References .............................................................................................................................................17 iii 1. Introduction1 What should be the principal objective of monetary policy and under what conditions might the pursuit of that objective be constrained by other considerations? In the aftermath of the “Great Inflation”, experienced by most industrial countries in the 1970s, the answer to this question was obvious. Central banks should pursue single-mindedly the objective of reducing domestic inflation to a low level. This was seen, at the time, as the key contribution central banks could make to maximising output growth and, hence, human welfare over time. They should then take steps to prevent inflation from rising again over the one- to two-year (near-term) policy horizon implied by perceptions about the length of the lags in the monetary transmission mechanism. More recently, in light of sporadic episodes of deflation and threatened deflation in some countries, this same objective of keeping inflation at a low positive level has been restated in a rather more symmetrical way. Prices should neither be allowed to rise nor fall to any significant degree. The extent to which this consensus prevails is also reflected in the growing number of countries which have announced explicit inflation targets, often with the strong support of the international financial institutions. Closely related, there has been a clear trend towards giving central banks instrument independence to facilitate the achievement of this objective and holding them accountable for doing so. In sum, it is now the conventional wisdom that the principal objective of central banks should be to pursue price stability vigorously. It will be argued in this paper that price stability is indeed desirable for a whole host of reasons. At the same time, it will also be contended that achieving near-term price stability might sometimes not be sufficient to avoid serious macroeconomic downturns in the medium term. Moreover, recognising that all deflations are not alike, the active use of monetary policy to avoid the threat of deflation could even have longer term costs that might be higher than the presumed benefits. The core of the problem is that persistently easy monetary conditions can lead to the cumulative build-up over time of significant deviations from historical norms – whether in terms of debt levels, saving ratios, asset prices or other indicators of “imbalances”. The historical record indicates that mean reversion is a common outcome, with associated and negative implications for future aggregate demand. In a recent paper, Romer and Romer (2002) have argued that macroeconomic policymakers in the United States were basically using the right empirical model to conduct monetary policy in the 1950s. That is, policymakers at that time recognised the high cost of inflation, and were rightly convinced by Keynesian arguments that active monetary and fiscal policy could be used effectively to lean against it. They argued further that these insights were somehow lost in the 1960s and 1970s, allowing inflation to become well entrenched, but then (and fortunately) the eternal verities were rediscovered and inflation was resisted once more. Romer and Romer thus conclude that we are essentially back where we were in terms of our understanding of economic and, above all, inflationary processes. In contrast, it will be contended here that any historical exegesis needs to be extended in time, and thus in scope, to encompass the debate which took place before the occurrence of the Keynesian revolution. The literature produced by the Austrian school of economics in the interwar period concluded that the Keynesian focus on aggregate measures in the economy, like the overall measure of inflation, provided an inadequate bellwether for identifying emerging macroeconomic problems. Rather, the Austrians focused on the impact of changes in relative prices leading to resource misallocations and subsequent economic crises. Moreover, this literature treated economic developments as part of dynamic processes in which past events had an influence on the future. The long run was not just a series of short runs. In our modern world, where journalists, politicians and other non-academic commentators constantly use such terms as “excessive”, “unbalanced”, and “unsustainable”, these pre-Keynesian insights might still have a capacity to enlighten. In the more 1 A revised version of a paper presented at the Swiss National Bank Festschrift seminar at Gerzensee on 20-21 January 2006. Comments are welcome prior to the publication of the Festschrift volume in 2007. The views stated herein are those of the author and are not necessarily the views of either the Bank for International Settlements or those that have commented on the paper already. Nevertheless, my thanks to Stefan Gerlach, Már Gudmundsson, Ulrich Kohli and Øyvind Eitrheim for helpful comments, and to Claudio Borio both for comments and for ongoing stimulus about these and related issues over the course of many years. 1 formal models used by academics, these concepts are rarely present, perhaps because they are so difficult to model quantitatively in the first place.2 A starting point for the analysis in this paper is the explicit recognition of an increasingly obvious fact. Under the joint influences of deregulation and technology, the global economic and financial system has undergone massive change in recent years. The liberalisation of the real economy, in particular the re-entry into the global trading system
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