Worrying about inflation?

For at least a year there have been investors and commentators concerned about a resurgence of inflation in the US and Europe. Inflation has already risen in some other economies, including China, but that is partly to be expected in fast growing economies, especially those with many restrictions on markets. Food inflation is one factor behind the popular demonstrations in north Africa.

But in the mature economies with credible central banks, I believe the concern with inflation is overdone. Those who worry point to the use of quantitative easing in the US and UK and (unofficially) in the Eurozone. In all cases the central bank is funding the purchase of government debt with money that is, in effect, created. This is very similar to the traditional and historically usually disastrous process of printing money to fund a government deficit.

Some of the critics are respectable economists. Many, I suspect, learned a very little economics at university or have since picked up what they think is the truth, that “money is always and everywhere a monetary phenomenon”. This famous statement by the late Milton Friedman reflects the so-called monetarist belief that control or the lack of it over the money supply is necessary and sufficient for determining inflation.

Keynes in the 1930s argued that monetary policy in a slump could be impotent – once interest rates are very low then they can’t be cut further. The heads of the US and UK central banks obviously agree with this, hence their use of unorthodox policies to inject liquidity into the slow growing economies and try to push down the long term rate of interest. Normally they only target the short term rate of interest, which central banks can do very effectively.

Professor Frank Hahn, a brilliant economic theorist at Cambridge University who co-wrote the definite text on general equilibrium theory with Nobel laureate Ken Arrow, showed long ago that Friedman’s statement was incorrect by providing an example in which inflation occurred independently of a change in the money supply. Professor David Hendry, a leading econometrician based at Oxford University, destroyed the empirical justification for 1980s-style monetarism in the UK. Indeed the word monetarism has dropped out of fashion because it simply didn’t work.

But I have a simpler reason for believing that inflation will not be allowed to get out of hand in the UK or Eurozone, though there is a bit more room for doubt in the US (but not much). The Bank of England and the European Central Bank are legally independent of politicians and each has a clear policy mandate to keep inflation down. The UK has a target of 2% and the ECB interprets “price stability” as a target of no more than 2% inflation. If they hit these targets, both banks can then consider the wider goal of high employment and economic growth.

The sort of people who become central bankers are concerned with intellectual achievement, power and authority and their position in the history books, particularly those concerned with central banking. Their utility function is likely to be rather asymmetric. If they succeed in keeping inflation down they join the list of those contributing to sound money. This is especially important in the Eurozone, which is essentially an internationalisation of the old Deutsche Mark .

If by some error or misjudgement the central banks allow inflation to rise sharply away from their targets they will go down in history as incompetent, joining the very embarrassing list of those who failed their duty. Arthur Burns, chairman of the Federal Reserve from 1970-78, has the dismal reputation of allowing inflation to rise and giving in to political pressure to keep unemployment down. It took his successor, Paul Volker, to kill off inflation through the costly use of very high interest rates which caused a steep recession and bankrupted most of Latin America. Volker remains a hero in the central banking world.

Even worse, for the head of the ECB, would be to be compared with the Reichsbank which presided over the famous German hyperinflation of 1923-24, which peaked at around 3 million per cent a month.

The chairman of the Federal Reserve has a dual mandate, to hit low inflation and high employment, which allows for more discretion. But the shadow of earlier inflation failures at the Fed is still very dark.

In sum, the heads of these institutions would rather cause mass unemployment for a while than let inflation rise too high. They know that once inflation rises, the cost of beating it also rises fast. But, unlike with deflation, they know with near certainty how they can kill it off – with sufficiently high interest rates. Their personal sense of duty, position in the history books and intellectual temperaments all incline them to keeping inflation down, whatever it takes. Therefore they will.