Low and steady wins the race

Following the 1979 OPEC crisis, governments from developed countries across the globe recognised the need to bring inflation – the rate of increase in prices over time – under control. Sparked by a decrease in oil output due to the Iranian revolution, oil prices rose from USD$15.85 to USD$39.50 a barrel over the course of a 12 month period. Along with it came increased prices as U.S. inflation grew from 9.3% to its peak of 14.8% (1980).

This imposed significant costs on American citizens, impacted by fantastically large price increases. High inflation levels ate away fixed-wage and pension levels, dried up savings and left consumers with little purchasing power. Investment worsened as creditors lost out to debtors, and long-term interest rates rose to combat rising prices leaving borrowings at all time lows. Fluctuations to the price system distorted decision-making and shoe leathers were well worn down by the need to ferry to and from the bank to save what value was left in the greenback.

Suffice to say conditions were not ideal and high inflation came at a cost so high that former Federal Reserve Chairman Paul Volcker initiated a policy of high interest rates and economic contraction to bring things back to order, and restore faith in the dollar. Beginning in 1981 U.S. inflation was clawed back from excess to just 3.2% by the end of 1983.

Today, in contrast, we face a different yet  equally concerning economic situation. Rather than the sharp increase in oil prices of the 1970’s, since June 2014 oil prices have plummeted from USD$115 to around USD$50 today constituting a decline of greater than 50%. With falling oil prices has come the sharp deterioration of prices, causing inflation to drop to as low as 0.1%, 0.2% and -0.3% across the U.S., U.K. and Europe respectively, and with it apprehension regarding the threat of deflation hangs in the air.

Just as in the case of high inflation, extremely low inflation imposes further severe economic consequences. Debtors are worse-off by the increased cost of debt repayments, further decreases to borrowing and investment arise as a result, and despite the increase in purchasing power for consumers, a decrease in consumption often occurs as we hold off spending in expectation that prices will get even lower. Japan’s economy continues to be the poster-child for the contractionary pressures of deflation, experiencing stagnant growth, weak confidence, and ultimately necessitating the 2013 appointment of Central Bank Governor Haruhiko Kuroda to end deflation by whatever means necessary.

Thus the course of history speaks to the imperative of the Government and its Central Bank to keep inflation under control. But what does under control mean exactly? Across the G7 the general target inflation rate is approximately 2%, with small fluctuations. Making this credible commitment enables people to believe in the value of their currency throughout time, deterring unstable inflation expectations that can give way to spiraling price changes, and the destructive consequences above.

Opponents of inflation targeting argue that this small margin leaves little room to impose expansive monetary policy when necessary. Although a valid point, monetary policy enacted during the Global Financial Crisis (2008) reveals the lack of basis for these concerns. When the ‘lower bound’ of interest rate adjustment (0%) was reached the apocalyptic end of monetary policy was not realized. Instead Central Bank’s were able to continue to pursue expansionary monetary policy through admittedly less conventional but nonetheless effective means: the manipulation of a central bank balance sheet. Although time will tell the true impact of quantitative and credit easing there is significant data to suggest that they were effective in lowering long term interest rates to stimulate durable investments, and reducing highly illiquid risk premiums to provide markets with some much needed relief.

Thus while extremely high and extremely low levels of inflation have been consistently proven to impede economic activity, little practical evidence exists for the need to substantially raise inflation levels above their low target ranges. The question then becomes why not just drive inflation to zero and experience the ultimate degree of price stability? After all it is only on account of inflation that prices have increased almost 75% over the 22 years since inflation targeting has been implemented. Many economists including Milton Friedman, and Robert Lucas staunchly proposed that even a little bit of inflation created noise in an otherwise well-designed price system – wreaking havoc with its ability to allocate resources and reveal preferences. Despite these concerns the truth is a little inflation comes in handy.

Originally conceived by Keynes in among his many valuable contributions to the economic field was the concept of downward nominal wage rigidity. Put simply, throughout time the economy inevitably experiences negative and positive shocks in all sectors. Whilst a positive shock is a cause for cheer – leading to an increase in sector wages, a negative shock creates a need for wages to decrease. However as the world does not (thankfully) conform to economic realty such decreases are generally ill received, and often lead to unnecessary lay-offs in its place. But where a low level of inflation exists rather than having to decrease wages, firms can simply not increase wages by the full extent of inflation. The consequential loss of purchasing power is a necessary adjustment in the sector, and can be achieved without a blow to unemployment. Thus for the sake of ‘greasing the wheels of the labour market’ a little inflation might be better in the long run.

Only through credible inflation targeting do central banks set an agenda for full employment, by creating the ideal monetary conditions that balance the need for price stability with some flexibility in the light of economic shocks. An often un-sung and underappreciated hero of policy today, inflation targeting continues to confer benefits on society. We do well to abide by the timeless principle first outlined by the tortoise and the hare, and maintained by central banks across the globe that low and steady wins the race.