Is there really a credibility problem in the face of deflation?

Tim Young, in typically combative style, doubts in a comment on this blog that there really is a credibility problem in the face of deflation.  I accept that historically, and theoretically, we have focused on the difficulty of persuading the private sector that we will not generate too much inflation, thereby eroding the real value of nominal government debt, nor nominal wage contracts.

However, there are two genuine doubts that observers of a central bank might have.

First, there is the doubt that, whatever they say about how confident they are, central banks may not have potent or reliable tools to fight deflation in the face of the zero bound.  The Bank of England has reassured us that ‘we have the tools’.  But perhaps they haven’t.  We know that they have a vested interest in reassuring us because in so doing, they help anchor inflation expectations, and thus inflation itself, and thus make their lives easier.

Second, there lurks the suspicion in the popular mind that central banks are actually inflation nutters and would really like 0 inflation, rather than the 2 per cent actually mandated.  Sure, we had a history of governments in the UK and elsewhere generating too much inflation.  But monetary policy was then supposedly passed on to these central bank types to solve that problem.  Perhaps this was overdone?  If you think this is far-fetched, note that several official remarks about our sub-target inflation, and remarks by prominent commentators, have been approving of the benefits of 0 inflation.

So, for those reasons, I think Marvin Goodfriend was right to warn that there is a credibility issue in fighting deflation, or at least sub-target inflation, and, accordingly, a motive for monetary policy to lean towards the vigorously stimulative.


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11 Responses to Is there really a credibility problem in the face of deflation?

  1. I’ve always felt that rich and powerful people, and the (private) institutions they control, have a vested interest in keeping inflation down, no matter what harm the deflation causes. That’s kind of obvious, but unfortunately it doesn’t seem to be discussed properly. The government owes money via bonds and many normal people owe money via mortgages. Everyone else is (on average) either a normal person with essentially negligible assets and liabilities, or a rich person with lots of (money-like) assets.

    Consciously or otherwise, these rich people will always vote for extreme policies on inflation. If you can bribe the powers-that-be into missing inflation by 1% for one year, you get an extra return of 1% on certain classes of assets. Easy money if you’re a billionaire. And, you don’t need to think about explicit corruption via bribes to MPC members; this kind of selfishness happens automatically.

    There are suggestions on how to solve this, but I want to make a more general point. Economic modelling should explicitly include this kind of feedback. Given “official” policy X (the inflation rate and targeting mechanism or whatever), we should predict the incentives this gives to rich people, and therefore what the policy will *actually* be once rich people (including those people that decide monetary policy) have had a change to “tweak” the policy.

    Instead of pretending we can ban such incentives, wishing them away with a magic wand, we should accept they exist and adjust the policies themselves to take account of this. For the sake of argument, a price level target, instead of the current price rate, would essentially destroy these corrupt incentives. But even if you don’t like level targetting, the general point about incentives, and the resulting corruption, still stands.

    • I think the ratio is about 80% of individuals owe money (liabilities greater than assets), 10% are neither in debt, nor have significant assets, and 10% own all the assets. But I have not looked at exact wealth distribution lately.

      Your point is a very good one, if the target is not met (less than 2% inflation), the rich gain.

      Even if the 2% inflation target is met, it might be met entirely because, say energy costs have risen. Now cost of energy is really a cost which is highly regressive. So poor people pay a lot more (as %age of income) for their energy needs. Again the rich gain (relatively).

      Inflation policies are of course made for the rich. Asset inflation is not included, so house and share prices can rise, no inflation.

      Low inflation policy is really a redistribution policy, From poor to rich.

      The problem with monetary economists is of course, that these fundamental questions are never really addressed.

      • Tim Young says:

        The idea that the rich dislike inflation is a lie (and I rarely use that word) spread by establishment and Keynesian commentators (like Paul Krugman) that needs to be exposed for what it is.

        Inflation hits relatively poor savers (obviously not the absolutely poorest, who by definition, would not be expected to have any significant savings – their fate depends on how well their income is indexed), like poor like pensioners and children, hardest, because, being relatively small and unsophisticated, the mainstay of their savings is monetary savings like bank accounts. Poor pensioners like my former next-door neighbours, who owned a pet shop and retired with their state pension supplemented by bank and building society savings, which have been crushed by BoE near-ZIRP. The most successful savings (not including pensions) incentive scheme in the UK by far has been the cash ISA. By contrast, the more wealthy tend to hold proportionately more savings in real investments, such as company stock and property, not to mention the art, classic cars etc, that are presently reaching record prices – such items would not be being bid up if the financially sophisticated really believed that deflation was about to take hold – and often end up sitting in bonded warehouses in Switzerland.

        So why do I think that the idea that inflation hits the rich is so often repeated? In part, it may derive from a naïve belief in the Keynesian idea of the rentier, who in his day held much wealth in gilts as the middle class had since at least Jane Austen’s time, but which is now outdated. But more dishonourably, albeit more likely unconsciously rather than some far-fetched conspiracy, I think that an unholy alliance of the establishment is trying to chip away at the consensus that inflation should be key objective of monetary policy for their own gain. This alliance comprises:
        (1) Established economic commentators and academics, comfortable with enough wealth in property (UK housing) and stock (UK pensions and US 401Ks) to keep them and their progeny in a position of advantage for the foreseeable future, and tending to mix with mostly people in the same position as them.
        (2) Investment (not commercial) banks, and other financial businesses which make money from inflated and inflating risky asset prices, either from holding risky assets on their own books or as agents, or by trading risky and complex assets with large spreads, and which therefore favour consistently easy monetary policy like QE that keeps these assets inflated.
        (3) Politicians pandering to property-owning voters and desiring low cost debt to service and borrow for their own use.

        The weak voice of the many small and unsophisticated savers with little access to the media goes almost unheard, but they are the ones who really lose out from inflation.

      • Lyn Eynon says:

        @ Tim Young

        Tim, your point about small savers losing out should be directed at interest rates rather than inflation. A cash ISA saver receiving 1% when RPI is 2% would be better off receiving 4% with RPI at 3%. It is low rates rather than any increase in inflation that has caused difficulties for such savers.

      • Lyn Eynon says:

        We cannot analyse who wins or loses from ‘inflation’ without specifying which prices we are considering. For some years after the initial shock of the financial crash, ‘core inflation’ was close to target (as least in the UK and US) but the value of financial and property assets rose steadily while wages stagnated and interest rates stayed low. That combination was clearly beneficial to the wealthy and detrimental to those depending on pay or cash savings.

        Over the past year this has looked less secure. Asset values have wobbled with the prospect of rate rises, property rests on an unstable growth in debt, wages have slowly risen, retail prices have flirted with deflation and global growth is slowing. In this context the primary concern of those with substantial wealth is to preserve their gains, which could be jeopardised by a rate rise lowering asset values with associated business failures and debt defaults. Inflationary fears seem for now to be secondary.

        For the rest of us the recessionary threat is the biggest worry. Monetary policy has shown its inadequacy near the zero bound and has little to offer unless backed by fiscal expansion.

      • Tim Young says:

        Strictly, it should be real interest rates that matter to the saver (I presume you messed up what you were trying to say above with your 1 and 2 and 4 and 3) – my old neighbours may not have been financially sophisticated, but I don’t think they were stupid enough to want higher interest rates regardless of inflation. But of course the real short-term interest rate depends on how seriously the central bank takes its inflation-priority mandate. And the facts are that on average, the BoE has overshot its inflation target, while real short-term interest rates have been strongly negative since the financial crisis, with CPI having topped 5% a couple of times since the financial crisis, with the BoE repo rate stuck at ½% since early 2009.

        What BoE officials (like Paul Tucker I can remember) occasionally say about low interest rates that promote a strong economy being good for everyone is disingenuous sophistry. It may sound mean, but the fact is that people long interest-bearing assets may well take that position because they consider that an impending correction of overdone economic activity or asset prices makes a long position the best strategy to take advantage, and they may not unreasonably hope for a collapse as much as those on the other side of the trade want the good times to continue. Of course, the holders of debt assets run the risk that they don’t get paid if the borrower defaults, but, depending on the nature of the borrower, they may still emerge with a large fraction of their money from the resulting bankruptcy wind up, and of course UK holders of deposits have about €100,000 worth of protection of deposit insurance paid for by the whole UK financial industry. Indeed, such stay-in-cash-and-wait-for-the-crash investors may constitute the mainstay of a natural restoring force that stops the collapse going too far, by effectively selling their debt post-collapse to pick up cheap assets that the chancers are forced to liquidate. It is not for central bankers to choose between the two sides of debt contracts.

      • Lyn Eynon says:

        Tim, that real interest rates matter to the saver is exactly the point I was making. Read my example again: it shows that a real rate of +1% is to be preferred to one of -1% even if inflation is higher.

        On your substantial point that “it is not for central bankers to choose between the two sides of debt contracts” I would argue that such choices – one way or the other – are unavoidable if central banks are to deliver on their mandates.

        These mandates are not restricted to achieving an inflation target. The BoE describes its mission as “promoting the good of the people of the United Kingdom by maintaining monetary and financial stability”. Financial stability obliges the Bank to consider debt contracts and its decisions could be to the benefit or loss of either side of these contracts. The Bank worries about borrower costs and defaults but also about the impact on lenders. Tony reminded us in this blog on 15 September that the Bank decided in 2009 not to cut rates closer to zero as this would reduce bank profits and could destabilise some institutions.

        The October MPC minutes summary starts by stating that it “sets monetary policy in order to meet the 2% inflation target and in a way that helps to sustain growth and employment”. It goes on to explain its intention to set policy to “ensure that growth is sufficient to absorb any remaining underutilised resources” which is expected to support domestic cost growth ensuring the return of inflation toward 2%. With inflation below target there is no tension with the growth and employment objectives but there could be as inflation rises. Further, as the MPC has a choice of instruments (including quantitative adjustments of various flavours) inflation could be targeted through a range of interest rates depending on the policy mix.

        If we then bring the FPC into the picture and consider the impact on monetary growth of macroprudential regulations and ratios, plus joint initiatives with the Treasury such as the Funding for Lending Scheme, it becomes still more apparent that achieving monetary and financial stability involves the Bank in much more than just choosing an interest rate to target inflation. Any chosen set of policies will have distributional effects on either side of debt contracts that differ from those that would result from an alternative mix.

        Such choices cannot be avoided so monetary policy cannot be reduced to technical decisions isolated from politics. This is one reason why John McDonnell is right to call for a review of the Bank’s mandate.

      • Tim Young says:

        No. The BoE is supposed to be above political considerations, because experience suggests that taking account of them ends in inflation. If Tony said that “the Bank decided in 2009 not to cut rates closer to zero as this would reduce bank profits”, and this is true (I dare say that there are market reasons for not wanting to cut the base rate to zero), the BoE would be exceeding its mandate. And if the MPC think that it “sets monetary policy in order to meet the 2% inflation target and in a way that helps to sustain growth and employment” they are out of order. The BoE’s mandate makes in clear that it is only supposed to support government objectives for real variables like growth and employment “subject to” its inflation target being met.

        This is the key weakness of central bank independence. Provided that a central bank is erring on the populist side, the mechanisms to correct it in a country like the UK are weak. Another weakness is that they do their own inflation forecast, so that they can always claim that they are on track to meet their target. They can only really be judged on their forecast record and their closeness to the target over the long run, and the evidence is clear that they have erred on the dovish side in both cases.

        The problem with choosing one side of debt contracts (on average of course; arguably the essence of monetary policy is to chose one side or the other for short periods with no long-run bias) is that it is futile. If you keep short-changing creditors to the benefit of debtors, as the BoE has allowed since the early years of BoE independence, the market simply shifts the terms of the contract, perhaps plus a risk premium that makes debt more expensive for debtors, until the authorities undo the bias by a painful period of bias the other way with high real interest rates. The UK should have learned this from its experience in the 1970s and 80s, but despite that, we have created a dovish bias at the BoE, by selecting dovish central bankers who either genuinely think that way or schemers deliberately signalling dovish intentions to curry favour with the politicians who appoint and promote them.

      • Lyn Eynon says:

        The argument that ‘the Bank is supposed to be above political considerations’ assumes that this is possible. It is not.

        There is not a simple relationship between one instrument (interest rate) and one outcome (inflation). Not only are those concepts constructed composites but there are several instruments under the Bank’s control and a multiplicity of outcomes as well as inflation. Some of those impact government finances through borrowing costs and income distribution, such as between lenders and borrowers. So monetary policy under the control of the Bank impinges on areas which are usually regarded as the province of elected governments. Hence the Bank cannot be outside politics.

        That does not mean that the Bank should have no discretion or be reduced to a department of state but its relationship to government and the wider society is complex. It cannot be reduced to abstract ‘independence’ but must be defined in tangible terms such as its mandate, its tools and powers, its rules of engagement with the Treasury, how governors and committees are appointed, how it is made accountable for its decisions, and so on. All of which, in a democracy, should be subject to political negotiation and periodic review.

        It’s debatable how much of a ‘dovish bias’ the Bank has shown since ‘independence’ but today the inflation risks are greater on the downside.

      • Tim Young says:

        I completely disagree. In my opinion central bank over-reach – ie the perceived Greenspan Put – was part of the cause of the financial crisis. I agree that it is hard for central banks to be politically independent, but rather than accept central bank politicking, every attempt should be made to squeeze it out. In the BoE’s case, I would prefer to see MPC appointments made by the Treasury Select Committee rather than the government, and I would make their terms longer and unrenewable. Interest rates (or rather base money supply, for which the short-term interest rate is an indicator of effect) may not be the only instrument that bears on inflation, but it is good enough, because providing that the government and other economic actors know that the central bank will not compromise on pursuing its inflation objective, they will not try to avoid the cost of using their own instruments to support the central bank in its task, such as fostering good labour relations, as in Germany. The possibility of ducking real economic challenges by shifting the monetary yardstick should be so remote that economic actors simply assume a stable value of money, and get on with it.

        And I see little danger of significant deflation as long as money supply is not contracting. That is one lesson that we should have learned from Japan, where for all the hype, deflation averaged a negligible value of about 0.4% during its deflationary period. In fact, I suspect that what Japan shows is that when inflation gets so low that indexing habits die out, inflation drops into a stable channel of about zero, in which case attempts to raise it back to, say 2% may well be damaging, so that, in addition to bolstering central bank independence, we should be reducing the inflation target towards zero.

  2. BJH says:

    There’s a whole literature on this, no? Eggertsson’s committing to be irresponsible:

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