Friday, May 26, 2006

Is Price Stability Enough?

Very rarely do I come across an economic reading that is worth delving into. As a value investor, my economic realm tends to be micro-  rather than macro oriented. But  a recent paper is worth thinking about.

Resourceinvestor.com
highlighted this interesting paper, entitled "Is Price Stability Enough?" The article is written by William White, an economist at the Bank for International Settlements.

Being old enough to have seen WIN buttons (Whip Inflation Now) and having  presided over the asset-liability matching for an annuity driven life insurance company in the late 70's and early 80's, I embraced the plan of Paul Volcker to stymy inflationary thinking. As a  portfolio manager in the 80's and 90's I embraced the notion of disinflationary stocks completely, as well as rode the bond market's rally or yield collapse. Drummed into most of us in that era was a resolve to believe that economic growth and economic policy that embraced disinflation was tightly correlated. Watching the economic experience of Japan through the 90's reminded us that deflation was an even more difficult issue to overcome...even zero real rates would not be stimulative when the country was awash with capacity.

In this paper, White suggests that pursuit of price stability might have to be applied more flexibly and with a longer-run focus than has been the case for most central banks.

Having price stability as the hallmark of central bank policy is no guarantee of growth. White notes that "A preceding period of price stability is not sufficient to avoid serious macroeconomic downturns." Extreme events (such as the Japanese collapse of the 90's, the emerging market crisis for Eastern Asia in 1997 and 1998 and the Great Depression) were preceded by credit-fuelled investment booms that occured during an era of stable inflation.

White argues that "a combination of technological change and deregulation has led to a quickening process of disintermediation from banks, growing reliance on market processes, globalization  and institutional consoldidation. In short, we now have a liberalized system which seems much more likely to show boom-bust characteristics than the previously repressed one."

He warns, "The longer the period of macroeconomic stability, the greater the underlying excesses in investment and borrowing are likely to become."

A corollary of inflation targetting in a relatively benign environment is to encourage excessive debt accumulation.

What should policy emphasize? Identify the serious imbalances first. Develop incentives to encourage monetary policymakers to respond. Why? Overextended corporate and household balance sheets can also be the source of significant “headwinds”, reducing economic growth to levels well below potential. As far as the providing incentives to policymakers to respond, they should express publicly their intention to respond to emerging financial imbalances even if, occasionally, this leads to an undershooting of near-term
inflation targets.


Bottom line, a little inflation may be a far better thing to contend with over the short term than the repercussions of the economic imbalances.

Overall, I think this is a worthwhile paper to contemplate this weekend from your lounge chair.

Have a good weekend!



3 Comments:

At 7:47 AM, Blogger Barry Ritholtz said...

Thanks for the homework!

Now I've got my weekend reading laid out before me

 
At 10:21 PM, Blogger kennycan said...

A good piece and almost Austrian in its analysis.

What is the connection between 1920s/30s US, 1980s/90s Japan and 1990s/2000s?

1920's US - technology breakthroughs come together as a deflationary backdrop to the decade. However, the Fed targets a "stable" inflation. In order to get to this they have to intervene in the mkt to get the negative deflation into positive territory. Overstimulating by 4-8% per yr for a decade they fuel a debt boom that busts in 1929.

1980's Japan - disinflation around the world sparked by Volcker's breaking the back of inflation and new mgt techniques (just in time inv mgt) provide a for a deflationary backdrop in Japan. Once again, while not having an inflation target, Japan's MoF and Central Bank are accomodative because inflation is tame. Another boom and bust is unleashed.

1990's US - I think you see the pattern. In an environment that should be deflationary, deflation is deemed unacceptable. Fueling a debt backed boom that is still running today. And I think ends just as badly. What triggers the change? It's never the same thing, perhaps its just change itself.

Inflation is not the CPI going up. It is the creation of more money than the economy needs to do what it would normally do in a laissez-faire environment. In laissez-faire, prices would go down if technology and organization structures were more productive. Forcing them to go up when they should go down requires excess money creation. In a system with Central Banks that involves excess credit (debt) creation to achieve this.

 
At 10:21 PM, Blogger kennycan said...

A good piece and almost Austrian in its analysis.

What is the connection between 1920s/30s US, 1980s/90s Japan and 1990s/2000s?

1920's US - technology breakthroughs come together as a deflationary backdrop to the decade. However, the Fed targets a "stable" inflation. In order to get to this they have to intervene in the mkt to get the negative deflation into positive territory. Overstimulating by 4-8% per yr for a decade they fuel a debt boom that busts in 1929.

1980's Japan - disinflation around the world sparked by Volcker's breaking the back of inflation and new mgt techniques (just in time inv mgt) provide a for a deflationary backdrop in Japan. Once again, while not having an inflation target, Japan's MoF and Central Bank are accomodative because inflation is tame. Another boom and bust is unleashed.

1990's US - I think you see the pattern. In an environment that should be deflationary, deflation is deemed unacceptable. Fueling a debt backed boom that is still running today. And I think ends just as badly. What triggers the change? It's never the same thing, perhaps its just change itself.

Inflation is not the CPI going up. It is the creation of more money than the economy needs to do what it would normally do in a laissez-faire environment. In laissez-faire, prices would go down if technology and organization structures were more productive. Forcing them to go up when they should go down requires excess money creation. In a system with Central Banks that involves excess credit (debt) creation to achieve this.

 

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