Should Central Banks dump inflation targeting?
Looking at the current financial markets crisis, rather than providing a path out of the current mess, credible inflation targeting may actually be making things worse. Eventually, inflation targeting may either have to be re-engineered or completely...
Looking at the current financial markets crisis, rather than providing a path out of the current mess, credible inflation targeting may actually be making things worse. Eventually, inflation targeting may either have to be re-engineered or completely abandoned.
To understand why, we have to think about what has been happening over the last year or so. House prices have plunged. Credit markets have imploded. Equity markets have crashed. Commodity prices, after the earlier boom, appear to be in freefall. Banks are refusing to lend to each other. Cash is being stuffed under the mattress. Companies are increasingly unable to get credit from banks, no matter how profitable their businesses are.
These events are extraordinary. They mark a crisis of confidence within the global financial system not seen since the Depression years of the early 1930s. They also reflect a desire to hold money, rather than any other asset, at any cost.
Financial panics are all associated with fear. We fear that others will sell their shares, or their bonds, or their houses before we do. We fear that others will keep their jobs while we lose ours. In the face of these manifest dangers we hoard something which should hold its value come what may. Cash can do this. It does it particularly well if the Central Bank, through its inflation target, is effectively guaranteeing the value of cash into perpetuity.
While the blame for the crisis is passed from bankers to regulators to governments to hedge funds like a game of musical chairs, the biggest current problem is a huge collapse in confidence which is leading to a massive hoarding of cash.
What does a sudden increase in demand for cash actually do to an economy? There is only so much money in the system. The more of it that is hoarded, the lower demand will be. That means falling prices, falling wages and the onset of deflation. Deflation, in turn, increases the real value of people's debts. They are forced to spend even less to deal with these debts and it is only a matter of time before the economy is facing a debt deflation. At the limit, if everybody hoards cash, the economy will completely collapse. It is, put in other words, the madness of crowds. Everybody thinks it is entirely rational to hoard cash. It is the sort of reaction if economic uncertainty increases. Collectively, though, it takes an economy on the road to ruin.
An inflation target makes things worse for two reasons. First, in a world of uncertainty, a credible inflation target provides certainty that cash will not lose its value. The credibility of the Central Bank can, therefore, be self-defeating when people are beset with financial fear. Second, inflation targeting supposedly lets bygones be bygones. If prices fell last year, or over the last few years, this supposedly makes no difference to the inflation target in the years ahead. But as prices fall, real debt levels go up. Letting bygones be bygones in a deflationary world increases the need to pay off debt quickly. If, though, everyone does this, demand slumps and prices fall even more.
In these circumstances, cash becomes a one-way bet. A government's or Central Bank's promise not to create inflation under any circumstances makes cash enormously attractive. If, in a world of fear (whether justified or not), people want to liquidate all their risky assets, they are entirely sensible to want to hold cash. They certainly cannot lose and, should the economy implode and prices collapse, they will believe they can win.
While it seems that interest rate cuts alone are not delivering the desired results in today's choppy financial waters, what could be done then? First, governments should not just borrow to bail out banks. Even if the capital injections work, banks will not be able to deliver the loan volumes they used to churn out before the crisis. A credit shortage will remain. In the absence of private demand, public demand will have to go up. Second, governments and Central Banks need to work together to re-define monetary objectives. Rather than an inflation target, they should be thinking of a price level target. This creates an extra degree of symmetry which reduces the risk of monetary hoarding. If prices fall as a result of the deflationary consequences of cash hoarding, it becomes incumbent on both the government and the Central Bank to push prices back up again. Put another way, a price level target provides a greater degree of stability for real debt levels and reduces the chances of a debt deflation.
A price level target, though, will be credible only if it has the full co-operation of both the monetary and fiscal authorities. In the absence of a banking system, another mechanism needs to be found to pump money into the economy to reduce the destructive effects of cash hoarding. Thankfully, John Maynard Keynes provided the answer in the 1930s. The government sells bonds directly to the Central Bank which, in turn, creates cash for the government to use in the form of tax cuts or, even more effectively, spending increases. By threatening to create inflation, the incentive to hoard cash is lowered and the threat of deflation is therefore reduced.
This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
To understand why, we have to think about what has been happening over the last year or so. House prices have plunged. Credit markets have imploded. Equity markets have crashed. Commodity prices, after the earlier boom, appear to be in freefall. Banks are refusing to lend to each other. Cash is being stuffed under the mattress. Companies are increasingly unable to get credit from banks, no matter how profitable their businesses are.
These events are extraordinary. They mark a crisis of confidence within the global financial system not seen since the Depression years of the early 1930s. They also reflect a desire to hold money, rather than any other asset, at any cost.
Financial panics are all associated with fear. We fear that others will sell their shares, or their bonds, or their houses before we do. We fear that others will keep their jobs while we lose ours. In the face of these manifest dangers we hoard something which should hold its value come what may. Cash can do this. It does it particularly well if the Central Bank, through its inflation target, is effectively guaranteeing the value of cash into perpetuity.
While the blame for the crisis is passed from bankers to regulators to governments to hedge funds like a game of musical chairs, the biggest current problem is a huge collapse in confidence which is leading to a massive hoarding of cash.
What does a sudden increase in demand for cash actually do to an economy? There is only so much money in the system. The more of it that is hoarded, the lower demand will be. That means falling prices, falling wages and the onset of deflation. Deflation, in turn, increases the real value of people's debts. They are forced to spend even less to deal with these debts and it is only a matter of time before the economy is facing a debt deflation. At the limit, if everybody hoards cash, the economy will completely collapse. It is, put in other words, the madness of crowds. Everybody thinks it is entirely rational to hoard cash. It is the sort of reaction if economic uncertainty increases. Collectively, though, it takes an economy on the road to ruin.
An inflation target makes things worse for two reasons. First, in a world of uncertainty, a credible inflation target provides certainty that cash will not lose its value. The credibility of the Central Bank can, therefore, be self-defeating when people are beset with financial fear. Second, inflation targeting supposedly lets bygones be bygones. If prices fell last year, or over the last few years, this supposedly makes no difference to the inflation target in the years ahead. But as prices fall, real debt levels go up. Letting bygones be bygones in a deflationary world increases the need to pay off debt quickly. If, though, everyone does this, demand slumps and prices fall even more.
In these circumstances, cash becomes a one-way bet. A government's or Central Bank's promise not to create inflation under any circumstances makes cash enormously attractive. If, in a world of fear (whether justified or not), people want to liquidate all their risky assets, they are entirely sensible to want to hold cash. They certainly cannot lose and, should the economy implode and prices collapse, they will believe they can win.
While it seems that interest rate cuts alone are not delivering the desired results in today's choppy financial waters, what could be done then? First, governments should not just borrow to bail out banks. Even if the capital injections work, banks will not be able to deliver the loan volumes they used to churn out before the crisis. A credit shortage will remain. In the absence of private demand, public demand will have to go up. Second, governments and Central Banks need to work together to re-define monetary objectives. Rather than an inflation target, they should be thinking of a price level target. This creates an extra degree of symmetry which reduces the risk of monetary hoarding. If prices fall as a result of the deflationary consequences of cash hoarding, it becomes incumbent on both the government and the Central Bank to push prices back up again. Put another way, a price level target provides a greater degree of stability for real debt levels and reduces the chances of a debt deflation.
A price level target, though, will be credible only if it has the full co-operation of both the monetary and fiscal authorities. In the absence of a banking system, another mechanism needs to be found to pump money into the economy to reduce the destructive effects of cash hoarding. Thankfully, John Maynard Keynes provided the answer in the 1930s. The government sells bonds directly to the Central Bank which, in turn, creates cash for the government to use in the form of tax cuts or, even more effectively, spending increases. By threatening to create inflation, the incentive to hoard cash is lowered and the threat of deflation is therefore reduced.
This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.