Inflation Targeting: the Original Sin

[ostap]

Inflation targeting has become the predominant monetary policy strategy in recent years. Although neither the Fed nor the ECB are inflation targeters, they too have implicitly adopted many aspects of the inflation targeting framework.

The alleged success of inflation targeting in bringing down inflation and inflation expectations is probably not due to the inflation targeting strategy itself, but first of all to globalization, in particular the integration of China into the world economy, which resulted in persistent downward pressure on goods prices in recent years. A second reason for the reduction in inflation was probably the concurrent granting of independence to central banks which hitherto had been part of the finance ministries. Interestingly, a recent ECB Working Paper (”Global Inflation”) finds that one common factor accounts for 70% of the variance of inflation in industrial countries, inflation targeting or not.
Although inflation targeting is consistent and beautiful in theory, in practice, it suffers from serious shortcomings.

Sometime at the beginning of the 20th century, it was agreed that the most suitable measure of prices for monetary policy purposes is the consumer prices index. Consumer prices indeed have some attractive features: they directly affect most citizens, they are easy to gather, quickly available and are not revised. However, consumer prices are just a small subset of all prices in an economy, and therefore far from a comprehensive measure of “prices”. Not least Alchian and Klein (1973, “On a Correct Measure of Inflation”, JMCB) challenged (unsuccessfully) the use of consumer prices for monetary policy purposes.

The technical simplification soon took a life of it’s own, and in the minds of people, “consumer prices” became equivalent to “prices”. For example, most of today’s economics textbooks assume right from the start that the consumer price level is the one and only aggregate price level in an economy. People nowadays use the term inflation when in fact they mean consumer price inflation, the quantity theory of money is being (mis)interpreted such that money affects consumer prices, and Milton Friedman is (mis)understood as claiming that consumer price inflation is always and everywhere a monetary phenomenon.

Due to this subtle change of meaning, central banks, correctly wishing to provide price stability, wrongly restrict their focus on consumer prices. Unfortunately, money does not care about that change in semantics - it still affects all prices, including non-consumer goods prices, commodities, real estate, stocks, bonds and exchange rates. Not only has that been forgotten; central banks nowadays actually even deny responsibility for other prices than consumer prices.

In the face of a large positive supply shock from globalization, consumer prices should have been allowed to fall in recent years. By targeting a positive consumer price inflation rate, monetary policy has been too expansionary when it comes to other prices. Central banks have thus triggered a tsunami of liquidity and credit, which, probably some day soon, will come home to roost.

Don’t get me wrong: the idea of inflation targeting, namely stabilizing prices, is great. The original sin is the narrow focus on consumer prices. I don’t pretend to know how a better monetary policy strategy should look like. However, I suggest to look back into history for other viable monetary arrangements. Many clever people in the past must have had a reason when advocating to include monetary or credit aggregates into a monetary policy strategy, or to peg a currency to some asset which cannot be inflated at will, such as gold.

From: www.economicreason.com

[Finster]

Re: Inflation Targeting: the Original Sin

Inflation targeting has become the predominant monetary policy strategy in recent years. Although neither the Fed nor the ECB are inflation targeters, they too have implicitly adopted many aspects of the inflation targeting framework.

The alleged success of inflation targeting in bringing down inflation and inflation expectations is probably not due to the inflation targeting strategy itself, but first of all to globalization, in particular the integration of China into the world economy, which resulted in persistent downward pressure on goods prices in recent years. A second reason for the reduction in inflation was probably the concurrent granting of independence to central banks which hitherto had been part of the finance ministries. Interestingly, a recent ECB Working Paper (”Global Inflation”) finds that one common factor accounts for 70% of the variance of inflation in industrial countries, inflation targeting or not.
Although inflation targeting is consistent and beautiful in theory, in practice, it suffers from serious shortcomings.

Sometime at the beginning of the 20th century, it was agreed that the most suitable measure of prices for monetary policy purposes is the consumer prices index. Consumer prices indeed have some attractive features: they directly affect most citizens, they are easy to gather, quickly available and are not revised. However, consumer prices are just a small subset of all prices in an economy, and therefore far from a comprehensive measure of “prices”. Not least Alchian and Klein (1973, “On a Correct Measure of Inflation”, JMCB) challenged (unsuccessfully) the use of consumer prices for monetary policy purposes.

The technical simplification soon took a life of it’s own, and in the minds of people, “consumer prices” became equivalent to “prices”. For example, most of today’s economics textbooks assume right from the start that the consumer price level is the one and only aggregate price level in an economy. People nowadays use the term inflation when in fact they mean consumer price inflation, the quantity theory of money is being (mis)interpreted such that money affects consumer prices, and Milton Friedman is (mis)understood as claiming that consumer price inflation is always and everywhere a monetary phenomenon.

Due to this subtle change of meaning, central banks, correctly wishing to provide price stability, wrongly restrict their focus on consumer prices. Unfortunately, money does not care about that change in semantics - it still affects all prices, including non-consumer goods prices, commodities, real estate, stocks, bonds and exchange rates. Not only has that been forgotten; central banks nowadays actually even deny responsibility for other prices than consumer prices.

In the face of a large positive supply shock from globalization, consumer prices should have been allowed to fall in recent years. By targeting a positive consumer price inflation rate, monetary policy has been too expansionary when it comes to other prices. Central banks have thus triggered a tsunami of liquidity and credit, which, probably some day soon, will come home to roost.

Don’t get me wrong: the idea of inflation targeting, namely stabilizing prices, is great. The original sin is the narrow focus on consumer prices. I don’t pretend to know how a better monetary policy strategy should look like. However, I suggest to look back into history for other viable monetary arrangements. Many clever people in the past must have had a reason when advocating to include monetary or credit aggregates into a monetary policy strategy, or to peg a currency to some asset which cannot be inflated at will, such as gold.

From: www.economicreason.com

Another outstanding post, O.

First the nit. The notion that globalization has kept inflation at bay, while popular (especially with central bankers and Wall Street economists), is deeply flawed. It is an artifact of the same error that pervades the remainder of the original inflation sin ... conflating consumer prices with inflation in general. While globalization has kept a lid on consumer prices, we cannot conclude that it therefore has kept a lid on inflation.

With that out of the way, it's hard to understand how, upon a full examination of the issue, it can even be argued that consumer prices are a reasonable proxy for overall inflation, especially as an output variable in a feedback-enhanced inflation control system. But that's precisely the problem - there has been virtually no serious case made to that effect. It is generally simply uncritically assumed to be the case.

And it's not merely an academic issue. The practical implications are enormously consequential. It turns out that consumer prices do track general inflation, but are an egregiously lagging measure. As a result, central bankers looking to consumer prices as evidence of the level of inflation they are targeting are perpetually far behind the curve. Right now, we are suffering the consequences of inflation that was being generated at least as far back as the bubble years of 1995 -2000. But at the time, the Greenspan Fed was looking at apparently benign consumer prices, convincing itself that a new era was upon it that allowed profligate monetary policy to proceed free of damaging consequences.

We are seeing those consequences now, and will continue to see them for a number of years. A weakening economy contemporaneous with troublesome inflation.

What's more, the same problem that comes from a misplaced focus on consumer prices is made worse by looking at so-called "core" figures. For of the subset of consumer prices that lag least - food and energy prices - are the very same ones discarded by "core" measures! However bad the focus on consumer prices as indicia of inflation, the use of "core" is bad squared.

As for what measure policymakers should be looking at, certainly those you cite are serious candidates. Here is another one: an inflation index I have developed expressly to reflect inflation in a broad and comprehensive manner. The latest chart is reproduced below. Note that unlike indices explicit in prices of "stuff" expressed in dollar terms, this one is explicit in the market value of the dollar expressed in "stuff". Invert the series, and you have the more familiar relationship of inflation being represented by a rising plot. As shown, the steep decline in the series over the past three or four years represents a very serious annual rate of inflation on the order of twelve percent. By the time this has fully worked its way into "core" consumer prices, it will take very stringent measures indeed - recalling those executed by Paul Volcker circa 1980 - to halt the vicious cycle.

[bart]

Re: Inflation Targeting: the Original Sin

Here is another one: an inflation index I have developed expressly to reflect inflation in a broad and comprehensive manner. The latest chart is reproduced below. Note that unlike indices explicit in prices of "stuff" expressed in dollar terms, this one is explicit in the market value of the dollar expressed in "stuff". Invert the series, and you have the more familiar relationship of inflation being represented by a rising plot. As shown, the steep decline in the series over the past three or four years represents a very serious annual rate of inflation on the order of twelve percent. By the time this has fully worked its way into "core" consumer prices, it will take very stringent measures indeed - recalling those executed by Paul Volcker circa 1980 - to halt the vicious cycle.

The FDI indeed is unique, well done and thought out and very much a contender in my opinion.

John Williams work is also a contender, although his work focuses more closely on just the US and does not have a global view like the FDI.
It does roughly track with the FDI too, although your points about lagging also apply.



My own work, mostly based on his, is another way to view inflation but I also defer to you & John especially since mine has a much greater focus on prediction.





By the way, do you have any plans to construct and display the FDI as an actual percentage?

[Finster]

Re: Inflation Targeting: the Original Sin

The FDI indeed is unique, well done and thought out and very much a contender in my opinion.

John Williams work is also a contender, although his work focuses more closely on just the US and does not have a global view like the FDI.
It does roughly track with the FDI too, although your points about lagging also apply.

[image]

Much credit to Williams for his SGS-CPI. It is hands down the best measure of US consumer prices I know of. It doesn't, however, address the issue that Ostap raises - which is that consumer prices are intrinsically not a measure of overall inflation. Consumer goods and services are but one sector of the overall price inflation picture. This is where the FDI comes in, essentially "zooming out" to get as broad a picture as possible.

My own work, mostly based on his, is another way to view inflation but I also defer to you & John especially since mine has a much greater focus on prediction.

[image]

By the way, do you have any plans to construct and display the FDI as an actual percentage?

You just have to click a little deeper on my site for that ... ;)

Here again, you need to read it "upside down" for the inflation rate ... that is negative values represent negative changes in dollar value - hence positive inflation.

[bart]

Re: Inflation Targeting: the Original Sin

Much credit to Williams for his SGS-CPI. It is hands down the best measure of US consumer prices I know of. It doesn't, however, address the issue that Ostap raises - which is that consumer prices are intrinsically not a measure of overall inflation. Consumer goods and services are but one sector of the overall price inflation picture. This is where the FDI comes in, essentially "zooming out" to get as broad a picture as possible.

Precisely and indubitably... and scary again how closely we're tracking.

And I'm still working on putting data together for an article to address Ostap's point directly too, and extremely preliminary results show that the full picture is both similar to the FDI and to the SGS-CPI, and is closer to the FDI.

It's not very surprising too, given how closely the actions of the the majority of central banks match each other and how similar the "fiddling" of their respective CPIs is too.

You just have to click a little deeper on my site for that ... ;)

Here again, you need to read it "upside down" for the inflation rate ... that is negative values represent negative changes in dollar value - hence positive inflation.

Well, that's certainly a start... but for those of us that are closer to normal (only occasionally including me ;)), how about a linear chart with actual percentages, and that doesn't have to be read while standing on my head? :eek: :p :rolleyes: ;)

[Finster]

Re: Inflation Targeting: the Original Sin

Precisely and indubitably... and scary again how closely we're tracking.

And I'm still working on putting data together for an article to address Ostap's point directly too, and extremely preliminary results show that the full picture is both similar to the FDI and to the SGS-CPI, and is closer to the FDI.

It's not very surprising too, given how closely the actions of the the majority of central banks match each other and how similar the "fiddling" of their respective CPIs is too.

Which springs to mind another thing that Ostap alluded to above - that monetary data ("...include monetary or credit aggregates... ") could be an alternative or supplement to consumer price data in informing monetary policy.

You wouldn't happen to know anybody who has made a study of that particular area, would you?

... just since you're "...putting data together for an article to address Ostap's point..." (... hint ... hint ...)

Well, that's certainly a start... but for those of us that are closer to normal (only occasionally including me ;)), how about a linear chart with actual percentages, and that doesn't have to be read while standing on my head? :eek: :p :rolleyes: ;)

After all this time, you otta know my policy on that by now ... I am right side up. It is the rest of the world that is upside down.

;)

[bart]

Re: Inflation Targeting: the Original Sin

Which springs to mind another thing that Ostap alluded to above - that monetary data ("...include monetary or credit aggregates... ") could be an alternative or supplement to consumer price data in informing monetary policy.

You wouldn't happen to know anybody who has made a study of that particular area, would you?

... just since you're "...putting data together for an article to address Ostap's point..." (... hint ... hint ...)

*mumble, mumble*... *splutter*... *hem, haw*... ;)

Not only is that what my Central Bank Watch page is all about, but it's very much a part of my efforts... and I'm sure that's a shock to your system. ;)

After all this time, you otta know my policy on that by now ... I am right side up. It is the rest of the world that is upside down.

;)

I deserved that... and will even abase myself a tiny bit... ;)

[Finster]

Re: Inflation Targeting: the Original Sin

*mumble, mumble*... *splutter*... *hem, haw*... ;)

Not only is that what my Central Bank Watch page is all about, but it's very much a part of my efforts... and I'm sure that's a shock to your system. ;)

I deserved that... and will even abase myself a tiny bit... ;)

You can probably guess what I was driving at; we've at least circumscribed it before. Remember that you and I have independent, complementary, yet congruent approaches to inflation. Curiously enough, it sounds a lot like what Ostap describes in the last sentence of his post:

Don’t get me wrong: the idea of inflation targeting, namely stabilizing prices, is great. The original sin is the narrow focus on consumer prices. I don’t pretend to know how a better monetary policy strategy should look like. However, I suggest to look back into history for other viable monetary arrangements. Many clever people in the past must have had a reason when advocating to include monetary or credit aggregates into a monetary policy strategy, or to peg a currency to some asset which cannot be inflated at will, such as gold.

Yours uses no price data. Mine uses no monetary data. Yours uses "monetary or credit aggregates". Mine uses a quantity "which cannot be inflated at will" (albeit not gold or any single asset). Their conclusions are not identical, but similar in their essentials.

Self-serving as it may sound, there is no doubt in my mind that if the Fed were using our measures in its inflation targeting, this country would be a lot better off.

[bart]

Re: Inflation Targeting: the Original Sin

You can probably guess what I was driving at; we've at least circumscribed it before. Remember that you and I have independent, complementary, yet congruent approaches to inflation. Curiously enough, it sounds a lot like what Ostap describes in the last sentence of his post:

Originally Posted by ostap
Don’t get me wrong: the idea of inflation targeting, namely stabilizing prices, is great. The original sin is the narrow focus on consumer prices. I don’t pretend to know how a better monetary policy strategy should look like. However, I suggest to look back into history for other viable monetary arrangements. Many clever people in the past must have had a reason when advocating to include monetary or credit aggregates into a monetary policy strategy, or to peg a currency to some asset which cannot be inflated at will, such as gold.

Yours uses no price data. Mine uses no monetary data. Yours uses "monetary or credit aggregates". Mine uses a quantity "which cannot be inflated at will" (albeit not gold or any single asset). Their conclusions are not identical, but similar in their essentials.

Self-serving as it may sound, there is no doubt in my mind that if the Fed were using our measures in its inflation targeting, this country would be a lot better off.

There's little question at all that your and John Williams (and to a much lesser extent, my) efforts at showing real inflation would make a huge difference in the country if they were understood and adopted... but none of it covers the issues around the vested interests of the Fed, the banks or indeed the current way the government (mis)uses it.


I will say my current public efforts show no price data on my inflation prediction efforts, or much about inflation either except on my CPI lies page. But what I've been working on very much will combine price and monetary data... but only for the US.


And to directly address the key point he made, and which both of us have noted before elsewhere on numerous occasions - there has been no monetary system in history, whether backed or not, that has survived the tests of history and the dark goals of a small percentage of men.

Until such time as that issue is truly & broadly recognized and effectively addressed, currency debasement will be the way of the world. It's not a happy thought or conclusion, but such are the actual historical facts.

[bart]

Re: Inflation Targeting: the Original Sin

aaaaaa aaaaa

Gesundheit? ;)

[Finster]

Re: Inflation Targeting: the Original Sin

There's little question at all that your and John Williams (and to a much lesser extent, my) efforts at showing real inflation would make a huge difference in the country if they were understood and adopted... but none of it covers the issues around the vested interests of the Fed, the banks or indeed the current way the government (mis)uses it.

This may be getting to the real nub of the problem. With all the resources and smarts at their disposal, one would think they could do better if they really wanted to. Before you can successfully address a problem, you first have to have the motivation to do it.

I will say my current public efforts show no price data on my inflation prediction efforts, or much about inflation either except on my CPI lies page. But what I've been working on very much will combine price and monetary data... but only for the US.

Please try to find purist Bart and send him back to us pronto...

And to directly address the key point he made, and which both of us have noted before elsewhere on numerous occasions - there has been no monetary system in history, whether backed or not, that has survived the tests of history and the dark goals of a small percentage of men.

Until such time as that issue is truly & broadly recognized and effectively addressed, currency debasement will be the way of the world. It's not a happy thought or conclusion, but such are the actual historical facts.

Indeed, even a gold standard is subject to criticism on the grounds that it can be abandoned at any time. This is what actually happened in the US, first, surreptitiously (around 1914), and then overtly (in 1933 domestically and 1971 internationally). It can even be argued that a government-sponsored gold backing is worse than none at all, since it ultimately it merely confers a false sense of security.

[grapejelly]

Re: Inflation Targeting: the Original Sin

From a System standpoint, time deposits that represent savings have a velocity of zero. As long as savings are held in the commercial banking system, they are lost to investment. The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.

Would you mind clarifying and explaining this? I thought, perhaps naively, that banks could lend a time deposits out subject to reserve requirements?

[bart]

Re: Inflation Targeting: the Original Sin

This may be getting to the real nub of the problem. With all the resources and smarts at their disposal, one would think they could do better if they really wanted to. Before you can successfully address a problem, you first have to have the motivation to do it.

Aye matey and even aarghh... as well as *sigh*.

Please try to find purist Bart and send him back to us pronto...

'Tis true that I've fallen behind on my Daily Affirmations lately.

But if you look at one of the key definitions of inflation being more money than goods, and then dig a bit deeper into the broad definitions of both money and goods, the combination of regular money measures like the M's and credit and goods measures like GDP just plain don't cover the entire picture.

It's not terribly different conceptually from the FDI and it's breadth and depth of input factors.

Indeed, even a gold standard is subject to criticism on the grounds that it can be abandoned at any time. This is what actually happened in the US, first, surreptitiously (around 1914), and then overtly (in 1933 domestically and 1971 internationally). It can even be argued that a government-sponsored gold backing is worse than none at all, since it ultimately it merely confers a false sense of security.

Thou speak sooth again. And on the other side, the combination of a gold standard and large discoveries of gold like during the California gold rush has very similar inflationary effects to what the Fed has been doing since 2002 or so.

Additionally, a gold standard during a real economic boom combined with low discoveries of new gold has a strong deflationary effect... as partially painted in William Jennings Bryant's famous "Cross of Gold" speech.

[Finster]

Re: Inflation Targeting: the Original Sin

'Tis true that I've fallen behind on my Daily Affirmations lately.

But if you look at one of the key definitions of inflation being more money than goods, and then dig a bit deeper into the broad definitions of both money and goods, the combination of regular money measures like the M's and credit and goods measures like GDP just plain don't cover the entire picture.

It's not terribly different conceptually from the FDI and it's breadth and depth of input factors.

If you were attempting to produce a competitor for the FDI, you could do that, but why not a cooperative effort? Given our different strengths, it would be more productive. With the caveat that free advice may be worth every penny you pay for it, mine would be to stick to your monetary knitting - with but one modification - calculate your monetary aggragate on a per-capita basis. Then apply my 'knitting' for the price stuff. Finally, assemble a composite of your per-capita monetarily-derived inflation series and my price-derived inflation series.

Presto! Entire picture covered.

Thou speak sooth again. And on the other side, the combination of a gold standard and large discoveries of gold like during the California gold rush has very similar inflationary effects to what the Fed has been doing since 2002 or so.

Additionally, a gold standard during a real economic boom combined with low discoveries of new gold has a strong deflationary effect... as partially painted in William Jennings Bryant's famous "Cross of Gold" speech.

This is the core theoretical problem with a single-commodity-based monetary system. All individual commodities have their own supply and demand dynamic. What if, say, some huge new discovery of high-purity ore just three feet underground occured? This may be a stretch, but something like this happened when the Spanish brought huge loads of gold and silver back to Europe from South America. High inflation in a hard money regime actually happened. There could also be a technological breakthrough making nuclear transmutation much cheaper than heretofore. (Imagine a Federal Reserve Bank of Los Alamos.) Or conversely, what if someone discovered a cancer cure in which gold was a critical ingredient? You could have a rapidly appreciating money, deflation, and falling prices. Ultimately, and ideally, you seek a neutral commodity of intrinsically constant value for your point of reference. Like I do with the FDI.

...

[WDCRob]

Re: Inflation Targeting: the Original Sin

Ultimately, and ideally, you seek a neutral commodity of intrinsically constant value for your point of reference. Like I do with the FDI.
...

From previous comments, this commodity is "time"?