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[LEFT]Economists in principle agree that inflation is a monetary phenomenon. However, as soon as an economist turns into a central banker, a peculiar metamorphosis takes place: instead of a monetary phenomenon, inflation turns into an output gap-phenomenon. Central bankers rarely ever mention money when talking about inflation, as was recently eloquently observed by Caroline Baum (Fed’s Inflation Analysis Ranks with Zimbabwe’s).
The disconnect is explained by the current central bankers’ creed that, although inflation is a monetary phenomenon in the long run, when inflation actually sets in, it is always a medium term “output gap” phenomenon. Most of today’s inflation targeting central banks believe that actual inflation can only arise when the output gap is positive, or in other words, when the economy is running above its potential. By simply avoiding an overheating of the economy, they believe that they can keep inflation in check.
But how can we reconcile the two views - first of inflation as a long term monetary phenomenon, and second, of inflation as a function of the output gap? Well, probably these views are not compatible in the long run.
We cannot be sure that inflation will stay anchored when monetary policy is only fine-tuning the business cycle and is neglecting long-term monetary developments. While the output gap is, by definition, stationary (meaning that it fluctuates around a constant mean, which is zero in this case), inflation is not stationary. Or in other words – there is no reason why, when economic growth is in equilibrium, inflation should also be in some kind of equilibrium, as there is no predetermined equilibrium for inflation. In the long run, equilibrium inflation is determined by money growth. For inflation to be anchored in the long run, money growth has to be anchored. However, an inflation targeting monetary policy which is exclusively reacting to the output gap and does not care about money does not anchor money growth.
It is conceivable that, under such a monetary policy, inflation will stay low for some time, i.e. for some business cycles, especially if inflation expectations are low. However, the long run cannot be kept off indefinitely, and inflation must in the long run be connected to money growth. If monetary policy reacts asymmetrically to positive and negative output gaps, as has probably been the case in recent years, money growth will be excessive and will, in the long run, necessarily cause inflation to increase. In practice, this will probably become apparent through exceptionally large inflation increases during economic upswings and exceptionally small inflation decreases during economic downswings. In the end, even stagflation is conceivable.
The disconnect is explained by the current central bankers’ creed that, although inflation is a monetary phenomenon in the long run, when inflation actually sets in, it is always a medium term “output gap” phenomenon. Most of today’s inflation targeting central banks believe that actual inflation can only arise when the output gap is positive, or in other words, when the economy is running above its potential. By simply avoiding an overheating of the economy, they believe that they can keep inflation in check.
But how can we reconcile the two views - first of inflation as a long term monetary phenomenon, and second, of inflation as a function of the output gap? Well, probably these views are not compatible in the long run.
We cannot be sure that inflation will stay anchored when monetary policy is only fine-tuning the business cycle and is neglecting long-term monetary developments. While the output gap is, by definition, stationary (meaning that it fluctuates around a constant mean, which is zero in this case), inflation is not stationary. Or in other words – there is no reason why, when economic growth is in equilibrium, inflation should also be in some kind of equilibrium, as there is no predetermined equilibrium for inflation. In the long run, equilibrium inflation is determined by money growth. For inflation to be anchored in the long run, money growth has to be anchored. However, an inflation targeting monetary policy which is exclusively reacting to the output gap and does not care about money does not anchor money growth.
It is conceivable that, under such a monetary policy, inflation will stay low for some time, i.e. for some business cycles, especially if inflation expectations are low. However, the long run cannot be kept off indefinitely, and inflation must in the long run be connected to money growth. If monetary policy reacts asymmetrically to positive and negative output gaps, as has probably been the case in recent years, money growth will be excessive and will, in the long run, necessarily cause inflation to increase. In practice, this will probably become apparent through exceptionally large inflation increases during economic upswings and exceptionally small inflation decreases during economic downswings. In the end, even stagflation is conceivable.