In country after country it is now becoming clear that we are heading for outright deflation. This is particularly the case in Europe – both inside and outside the euro area – where most central banks are failing to keep inflation close to their own announced inflation targets.
What we are basically seeing is an unanchoring of inflation expectations. What is happening in my view is that central bankers are failing to take responsibility for inflation and in a broader sense, for the development in nominal spending. Central bankers simply are refusing to provide an nominal anchor for the economy.
To understand this process and to understand what has gone wrong I think it is useful to compare the situation in two distinctly different periods - the Great Inflation (1970s and earlier 1980s) and the Great Moderation (from the mid-1980s to 2007/8).
The Great Inflation – “Blame somebody else for inflation”
Monetary developments were quite similar across countries in the Western world during the 1970s. What probably best describes monetary policy in this period is that central banks in general did not take responsibility for the development in inflation and in nominal spending – maybe with the exception of the Bundesbank and the Swiss National Bank.
In Milton Friedman’s wonderful TV series Free to Choose from 1980, he discusses how central bankers were blaming everybody other than themselves for inflation (see here)
As Friedman points out, labour unions, oil prices (OPEC), and taxes were said to have caused inflation to have risen. That led central bankers like then Fed chairman Arthur Burns to argue that in order to reduce inflation, it was necessary to introduce price and wage controls.
Friedman of course rightly argued that the only way to curb inflation was to reduce central bank money creation, but in the 1970s most central bankers had lost faith in the fundamental truth of the quantity theory of money.
Said in another way, central bankers in the 1970s simply refused to take responsibility for the development in nominal spending and therefore for inflation. As a consequence, inflation expectations became unanchored as the central banks did not provide an nominal anchor. The result was predictable (for any monetarist) – the price level drifted aimlessly, inflation increased, became highly volatile, and unpredictable.
Another thing which was characteristic about monetary policy in 1970s was the focus on trade-offs – particularly the Phillips curve relationship that there was a trade-off between inflation and unemployment (even in the long run). Hence, central bankers used high unemployment – caused by supply side factors – as an excuse not to curb money creation and hence inflation. We will see below that central bankers today find similar excuses useful when they refuse to take responsibility for ensuring nominal stability.
The Great Moderation – “Inflation is always and everywhere monetary phenomenon”
That all started to change as Milton Friedman’s monetarist counterrevolution started to gain influence during the 1970s and in 1979 the newly appointed Federal Reserve chairman Paul Volcker started what would become a global trend towards central banks again taking responsibility for providing nominal stability and in the early 1990s, central banks around the world moved to implement clearly defined nominal policy rules – mostly in the form of inflation targets (mostly around 2%) starting with the Reserve Bank of New Zealand in 1990.
Said another way, from the mid-1980s or so central banks started to believe in Milton Friedman’s dictum that “Inflation is always and everywhere monetary phenomenon” and more importantly they started to act as if they believed in this dictum. The result was predictable – inflation came down dramatically and became a lot more predictable and nominal spending/NGDP growth became stable.
By taking responsibility for nominal stability, central banks around the world had created a nominal anchor, which ensured that the price mechanism in general could ensure an efficient allocation of resources. This was the great success of the Great Moderation period.
The only problem was that few central bankers understood why and how this was working. Robert Hetzel obviously was and still is a notable exception and he is telling us that the reason we got nominal stability is exactly because central banks took responsibility for providing a nominal anchor.
That unfortunately ended suddenly in 2008.
The Great Recession – back to the bad habits of the 1970s
If we compare the conduct of monetary policy around the world over the past 5-6 years with the Great Inflation and Great Moderation periods, I think it is very clear that we to a large extent has returned to the bad habits of the 1970s. That particularly is the case in Europe, while there are signs that monetary policy in the US, the UK, and Japan is gradually moving back to practices similar to the Great Moderation period.
So what are the similarities with the 1970s?
1) Central banks refuse to acknowledge inflation (and NGDP growth) is a monetary phenomenon.
2) Central banks are concerned about trade-offs and have multiple targets (often none-monetary) rather than focusing on one nominal target.
Regarding 1) We have again and again heard central bankers say that they are “out of ammunition” and that they cannot ease monetary policy because interest rates are at zero – hence they are indirectly saying that they cannot control nominal spending growth, the money supply, and the price level. Again and again we have heard ECB officials say that the monetary transmission mechanism is “broken”.
Regarding 2) Since 2008 central banks around the world have de facto given up on their inflation targets. In Europe, for nearly two years inflation has undershot the inflation targets of the ECB, the Riksbank, the Polish central bank, the Czech central bank, and the Swiss National Bank etc.
And to make matters worse, these central banks quite openly acknowledge that they don’t care much about the fact that they are not fulfilling their own stated inflation targets. Why? Because they are concerning themselves with other new (ad hoc!) targets – such as the development in asset prices or household debt.
The Swedish Riksbank is an example of this. Under the leadership of Riksbank governor Stefan Ingves, the Riksbank has de facto given up its inflation targeting regime and is now targeting everything from inflation, credit growth, property prices, and household debt. This is completely ad hoc, as the Riksbank has not even bothered to tell anybody what weight to put on these different targets.
It is therefore no surprise that the markets no longer see the Riksbank’s official 2% inflation target as credible. Hence, market expectations for Swedish inflation are consistency running below 2%. In 1970s the Riksbank failed because it effectively was preoccupied with hitting an unemployment target. Today the Riksbank is failing for the same reason: It is trying to hit another other non-monetary target – the level of household debt.
European central bankers -- in the same way as in the 1970s -- no longer seem to understand or acknowledge that they have full control of nominal spending growth and therefore inflation and as a consequence they de facto have given up providing a nominal anchor for the economy. The result is that we are seeing a gradual unanchoring of inflation expectations in Europe and this I believe is the reason that we are likely to see deflation becoming the “normal” state of affairs in Europe unless fundamental policy change is implemented.
Every time we get a new minor or larger negative shock to the European economy – banking crisis in Portugal or fiscal and political mess in France – we will just sink even deeper into deflation and since there is no nominal anchor, nothing will ensure that we get out of the deflationary trap. This is of course the “Japanese scenario” where the Bank of Japan for nearly two decade refused to take responsibility for providing an nominal anchor.
And as we continue to see a gradual unanchoring of inflation expectations, it is also clear that the economic system is becoming increasingly dysfunctional and the price system will work less and less efficiently – exactly as in the 1970s. The only difference is really that while the problem in 1970s was excessively high inflation, the problem today is deflation. But the reason is the same – central banks refusal to take responsibility for providing a nominal anchor.
Shock therapy is needed to re-anchor inflation expectations
The Great Inflation came to an end when central banks around the world finally took responsibility for providing a nominal anchor for the economy through a rule based monetary policy based on the fact that the central bank is in full control of nominal spending growth in the economy. To do that ‘shock therapy’ was needed.
For example, the Federal Reserve starting in 1979-82, fundamentally changed its policy and communication about its policy. It took responsibility for providing nominal stability. That re-anchored inflation expectations in the US and started a period of a very high level of nominal stability – stable and predictable growth in nominal spending and inflation.
To get back to a Great Moderation style regime central banks need to be completely clear that they take responsibility for for ensuring nominal stability and that they acknowledge that they have full control of nominal spending growth and as a consequence also the development in inflation. That can be done by introducing a clear nominal targeting – either restating inflation targets or even better introducing a NGDP targeting.
Furthermore, central banks should make it clear that there are no limits on the central banks' ability to create money and to control the money base. Finally, central banks should permanently make it clear that you can’t have your cake and eat it too – central banks can only have one target. It is the Tinbergen rule. There is one instrument – the money base – and the central bank can only hit one target. Doing anything else will end in disaster.
The Federal Reserve and the Bank of Japan have certainly moved in the direction of providing a nominal anchor in the last couple of years, while most central banks in Europe – including most importantly the ECB – need a fundamental change of direction in policy to achieve a re-anchoring of inflation expectations and thereby avoid falling even deeper into the deflationary trap.
PS: This post has been greatly inspired by re-reading a number of papers by Robert Hetzel on the Quantity Theory of Money and how to understand the importance of central bank credibility. In that sense this post is part of my series of “Tribute posts” to Robert Hetzel in connection with his 70th birthday.
PPS: Above I assume that central banks have responsibility for providing a nominal anchor for the economy. After all, if a central bank has a monopoly on money creation then the least it can do is to live up to this responsibility. Otherwise it seems pretty hard to argue that there should be any central bank at all.