A New Approach to The Causes of Inflation and Inflation Targeting

Inflation is a fascinating phenomenon from an investment perspective. Naturally most of the focus and analysis comes from the bond markets, where inflation expectations largely guide the movements in bond prices. However should the rest of the investment community analyse inflation expectations in the same way? Moreover, is the focus on headline inflation the key to understanding economic prospects? In this article, I will answer 'no' to both of these questions.


Inflation Policy is Influenced by Historical Events

Political actions or ideologies only really acquire strength if they are accompanied by emotional involvement and, it takes significant macro events in order to get the public involved with the details of economic policy. However, when they happen, the ramifications can become deeply embedded.

In terms of inflation, consider the hyper inflation experienced by the Germans in the inter-war period. This has had a lasting cultural effect on the willingness of Germans to agree to anti-inflationary Governmental measures. Similarly, the inflationary period in the 70's has caused no end of academic spilt ink to be devoted to formulating headline inflation busting policies. Whatever it took, headline inflation had to be controlled.

Moreover, this approach can be seen in the remits of both the ECB and the Federal Reserve. Although the Federal Reserve is supposed to oversee growth and inflation, very few people argue for a focus on the former if it compromises-in the slightest- the latter.


Academic Focus on Inflation

However, the focus on inflation is not just limited to executive political decision making. Indeed, it is fascinating how this is the one area of policy that the free marketeers (Milton Friedman etc) will insist requires action. Friedman's work focused on the control of monetary aggregate growth as the key to beating inflation. Friedrich Hayek has suggested that currencies be allowed to 'compete' with one another, in order to impose an anti-inflationary discipline upon issuers. Most of the economists focusing on this area of research would advocate inflation targeting in order to keep the economy out of recession.

Inflation Induces Misallocations of Capital

However, it is to an earlier insight of Hayek's that I think attention should be focused. In 'The Pure Theory of Capital'. In this early work, Hayek attempts to explain the cyclical nature of industrial output in a systematic theory of capital. He warns of the dangers of misallocations of capital that are caused by the availability of cheap credit during the boom period. The resulting recession is lengthened by the difficulties inherent in restructuring this capital. Furthermore, this 'cheap credit' is induced by rapid relative movements in pricing.

So for example, if house prices are booming-after the dot com bust, housing, commodities and hedge funds became the new 'dot-com'-then credit issuers will be psychologically induced to issue cheap credit. I need not explain the outcome of this and how much misallocated capital was thrown at new house build in the US. Just look at this chart...

The greatest insights into how economic agents are induced into doing this is given in the behavioural finance research of Kahneman and Tversky. They demonstrate how people tend to use heuristics in order to make decisions under uncertainty and, rapidly changing prices (inflation) are a significant cause of uncertainty.

In this article, I am arguing that it is the effects of these misallocations that are the symptoms and the cause is the psychological inducements. However, you can have these misallocations-with significant effects-without having head line inflation.


Inflation without the Inflation?

As noted above, for historical reasons, the focus on fighting inflation has been on the headline numbers. However, it strikes me that recent history has highlighted the dangers of inflation without, err, the inflation! Combating head line inflation is, in my opinion, far too narrow a political course to guide. In the last few years, we have seen inflation in the risk seeking within housing, mortgage bonds, CDO's etc. All of which was watched over by the Federal Reserve.

 Indeed, Greenspan spoke of a 'bond conundrum' as he had tried to raise rates only to see the markets keep market rates low. Ultimately, was this a problem to Greenspan, given that his remit is headline inflation? I suspect not, or at least, not enough to propel him to act further. Unfortunately, the inflation remit of the Federal Reserve is set up to fight yesterday's battles.

Similarly, with European Sovereign Debt, the market merrily priced in peripheral debt at close to Bund levels for most of the naughties. The Greeks never had it so good. Again, the subsequent misapplications of capital are being dealt with today. Again, the ECB's inflation busting remit does not allow it to make considerations. Bizarrely of all, the history of Communist control in China has created an environment whereby their central authorities can look at these issues in isolation. 


Fighting Inflation in Future

I think a fundamental rethink in inflation targeting is needed. I do not argue for an abandonment of current head line inflation targeting however I do think that policy responses-as with Greenspan and the 'bond conundrum'-should be encumbered because of a narrow focus on inflation targeting. Indeed, Greenspan repeatedly warned of the dangers of derivative issuance. Moreover, Mervyn King has been devastatingly succinct on what he thinks about the banking system.

It's time to rethink Central Banks remits and, to stop forcing them to fight yesterday's battles.




Source:

Hayek, F.A "Denationalization of Money: An Analysis of the Theory and Practice of Concurrent Currencies" , Hobart Papers, Transatlantic Arts, 1977

Hayek, F.A "The Pure Theory of Capital", The Collected Works of F.A. Hayek, University of Chicago Press, 2007

Kahneman, Daniel and Tversky, Amos "Judgement Under Uncertainty: Heuristics and Biases", Cambridge University Press, 1982

The Expediency of Cutting Public Spending

One of the interesting aspects of the current problems with Sovereign Debt is that-for the first time ever-it is now politically expedient to talk about reducing Government expenditure as a share of GDP. I am aware that Margaret Thatcher achieved this, but I would question if her popularity stemmed from this or whether it was as a consequence of the economic growth plus populist policies on housing. Perhaps the reality is that Thatcher could not have achieved this without the growth in the private sector and/or selling off state industries. The latter produces a one time benefit to revenues.

No matter. The point here is that there does appear to be a wind of change on the issue. Such sentiment shifts are hard to achieve. If humans were rational, we could all sit down and see the benefit in curtailing excessive Government expenditure. However, abstract arguments are hard for people realise in practice. In reality, ideas have no resonance unless they are accompanied by emotional involvement.

It was the emotional involvement of Germans with hyper-inflation during the inter-War period that has largely shaped their consensual awareness of its dangers today. Similarly, there is no doubt that the UK (an invaded during the Second World War) views the political project of the EU with less stringency. For war bedevilled continental Europe (almost continually at war for at least 200 years) the EU project is about ensuring solidarity and harmony. Another example, can be seen in the reticence of Asian countries to depeg their currencies from the US Dollar. They remember, all too well, the aftermath of the Asian Financial Crisis in the late 90's.

Returning to the subject of this post, it is worth recalling how problematic it has proved to intellectuals to get across the idea that Government Spending should be curtailed. James Buchanan gave the greatest insight with his applications of game theory to public choice decision making. Milton Friedman talked of constitutional adjustments to enforce balanced budgets. Friedrich Hayek warned us over taking the 'Road to Serfdom'. Alan Greenspan endlessly promulgated the necessity to rein in Federal Spending. Nothing worked.

Prosperity begets power and no power exerts itself more forcibly or effectively than that of the control of the welfare state by the middle classes. The transmission mechanism of this power is, inevitably, the willingness, nay necessity, for politicians to have a beauty parade based on who can spend the most money. It takes a shock, similar to current events, for people to finally realise that the public spending that they demand is actually paid for by them. We can only hope that in the UK ,for example, the public realises the wastefulness and inefficiency of the previous regime, and in fact, of many of them before them.