The Contradictory Missions Of Central Banking: Stable Price Inflation And Economic Stability

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Summary

Main goals of central banks are stable price inflation and financial stability.

These goals are contradictory.

Central bank policies create yet more economic problems as a result.

Therefore, expect more central bank interventions and economic instability ahead.

The stated objectives of central banks around the world, including the Federal Reserve, usually can be broken down into two main parts: stable price inflation and financial stability.

Broadly speaking, the former policy is meant to protect the confidence in the currency, while the latter promotes the broader goals of economic stability and maximum employment. It should be noted that "stable prices" from a central banker's perspective does not mean unchanging prices. Instead, it refers to prices growing at a stable rate close to the stated price inflation target, typically between 2.0% - 2.5% these days. [1]

As financial stability affects economic stability, I'll refer to the second part of central banks' objectives as economic stability as broader economic developments are of interest here. But herein lies a serious flaw with central bank monetary policies: the supposed goals of stable price inflation and economic stability cannot be achieved independently as the two are interconnected. Central banks therefore cannot implement one set of policies to affect the former and another set of policies to affect the latter as whatever is done to shape the former affects the latter and vice versa.

In a progressing economy, increased production (the creation of goods and services people demand) will exert downward pressure on prices. In general, there are only two ways the overall price level can increase over the longer term: an overall drop in the level of production or an increase in the money supply (or some combination of the two). Conversely, prices in general will fall if there is an increase in production or a contraction of the money supply. Prices in general will therefore decline if the money supply remains unchanged as there now are more goods chasing the same amount of money (alternatively, the same amount of money chasing more goods). Under the conditions of an inelastic money supply, economic progress would therefore bring about lower prices - falling prices over time would be a sign of a growing economy.

Central banks' first objective, stable price inflation, is to counteract the price deflationary impact of increased production. Short of implementing policies to actually reduce production, they're left with the only option available that can counteract this price-deflationary trend: implement policies that inflate the money supply. That is, in a progressing economy the central bank must ensure the money supply expands fast enough to offset the increase in production and, on top of that, to ensure that it increases sufficiently to also bring about price inflation close to target. Conversely, in a declining economy where the quantity of goods and services produced fall, the central bank must implement policies that bring about a sufficient reduction in the quantity of money to avoid prices greatly exceeding the target.

We can now draw the following conclusions about the "required" monetary policy whenever the price inflation target is higher than zero percent:

1) In a progressing economy, the money supply must constantly grow at a faster pace than the increase in production

2) In a declining economy, the money supply must contract, but at a continually slower pace than the fall in production, and

3) In a zero growth economy, the money supply must expand at a rate equal to the stated price inflation target.

A simple example demonstrating these conclusions is presented below. In real life of course, counteracting changes in production with changes in the money supply is not straight forward and is in fact near impossible for many reasons. [2] Central banks therefore often fail to achieve price inflation targets.

Now, let's assume the relevant central bank actually manages to keep price inflation in close proximity to the stated target over some period of time. In a progressing or no growth economy, this means the money supply must have continually expanded during the same period. Let's further assume the money supply growth was generated through banks extending loans to business. But here is the problem: the increased money supply which was needed to keep price inflation growth stable sets the business cycle in motion! Which leads us to the main problem with central bank mandates: monetary policies implemented to promote stable price inflation will slowly but surely promote financial and economic instability.

Effectively, it is flawed central bank policies, evidenced in two related, but contradictory, mandates, that bring forth the business cycle which inevitably foster economic instability. And then of course, the onset of economic instability makes it impossible for central banks to meet their price inflation targets during extended periods. The monetary policies are self-defeating with ongoing monetary inflation constantly throwing punches at the economy until it finally drops due some combination of overconsumption and malinvestments which wreak havoc with production and wreck savings. Central banks can achieve either one of the two missions if they decide to; but they can never achieve both simultaneously.

Monetary policies aiming to achieve a price inflation target therefore fail to create economic stability and instead result in, ironically enough, central banks in constant disarray trying to solve a problem they themselves created with more of what caused it in the first place. It is a futile and self-defeating exercise which can only bring about yet more economic instability. Central banks aim to solve this conundrum by expanding their "toolkit." In the long run, this will only bring about greater economic instability as any intervention in the market place on a grand scale will inevitably do. Expect more central bank interventions and economic instability ahead.


[1] As of November 2016, the stated price inflation targets for the Federal Reserve, the European Central Bank, Bank of England and Bank of Japan is 2%.

[2] Challenges include, but are not limited to: money supply changes (inadvertently) directly affecting the level of production, estimating price inflation, what time perspective, time lag between changes in production and changes in money supply on prices, changes in the rate of saving, cyclical developments, international developments etc.

Disclosure: I am/we are short MYY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.