The Bear’s Lair: Zero is the right inflation target

Janet Yellen has said that she wants to consider raising the Federal Reserve’s target inflation rate from 2% to a higher level. By doing so, she hopes to impose more steeply negative real interest rates without the difficulties of abolishing cash or conducting state roundups of savers. Morally as well as economically, her call must be resisted and indeed reversed: If we must have a Fed, and that Fed must have an inflation target, the inflation target should be a big fat zero.

As Robert, Lord Liverpool, at that time Britain’s First Lord of the Treasury, put it in the House of Lords on May 26, 1818 “the tendency of an inconvertible paper money is to create fictitious wealth, bubbles, which by their bursting, produce inconvenience.” It must be remembered that Liverpool spoke those words seven years before the bubble and crash of 1825, so that the only substantial bubble in recorded British history was the South Sea affair of 1720, almost a century before. Yet he still had a better grasp of the monetary basics than any modern central banker. Truly Maynard Keynes and his monetary neo-Keynesians- have a lot to answer for!

There are three alternative means to manage a state’s monetary policy: a fixed commodity standard, with no central bank, a fixed commodity standard, with a central bank whose function is to issue modest amounts of paper money and stabilise the money market, or a fiat money system (which then must of its nature have a powerful central bank.)

We will come on to the third alternative, that chosen by the modern world, in a moment. Of the first two, I am somewhat inclined to favour the second (in that I differ from my esteemed co-author Professor Kevin Dowd.) A privately owned central bank, issuing modest amounts of paper and having a monopoly on doing so, and stabilizing the market, is a useful instrument in times of difficulty, such as the Barings crisis of 1890 and the earlier crises of 1825, 1857 and 1866. It can signal to the market through its discount rate, and can manage the inflows and outflows of gold from the system by balancing them with paper notes, by raising interest rates in times of crisis and by lending to distressed but otherwise solvent banks. It cannot cause inflation, because any excessive note issuance results in an outflow of gold from the system which produces a crisis that must be met by sharply higher interest rates.

Liverpool said, earlier in the 1818 session: “the best system of currency for any country, and particularly for a country such as this, is a paper circulation, measured by the precious metals as its standard, and supported in value by being convertible into cash at the pleasure of the holder. However, unless some limit (on note issue) is adopted, property will become insecure, and the circulation will be subjected to repeated shocks, that might cause great public calamity and individual suffering.” Without such a limit on paper money issue having been imposed, the 1825 bubble and crash took place, but in principle Liverpool was right, and by his Country Bankers Act of 1826 he imposed the system he recommended.

Moving forward 200 years and across the Atlantic, we have a fiat currency system, and essentially an all-powerful central bank, impervious to market forces (because funded by the U.S. Treasury.) For anyone of even a mildly free-market bent, this is clearly sub-optimal, because the Fed by its power puts such a heavy hand on the scales of the economy that the market is quite unable to make accurate determinations of value.

To return closer to a capitalist system, in which we claim to be operating, the Fed must at the very least choose a clear policy, which it then follows consistently. The 1978 Humphrey-Hawkins mandate, to pursue full employment while controlling inflation, fails on two grounds. First, its two mandates are often contradictory, therefore providing contradictory guidance to the Fed on what it should be doing. Second, experience has shown that it is no effective constraint on Fed policy, since in the 40 years of its existence it has allowed both Paul Volcker’s admirable stringency and the appalling sloppiness of Ben Bernanke and Janet Yellen. With only such a weak guide to Fed policy, the market lacks knowledge of likely Fed policies and is frequently hugely distorted by Fed whims. A market that can be misled and distorted by an unaccountable agency of government is not a free market, it is Gosplan.

The management of Gosplan nevertheless varies in capability from period to period. Sometimes, as in the agency’s early years of the New Economic Policy or the early reform years of Alexei Kosygin, it allows the economy to move forward without excessive distortions, other than an excessive penchant for heavy industry. At other times, as in the last years of Leonid Brezhnev, it relies on completely falsified statistics and is a mass of corruption, consequently condemning the economy to rapid decline. Since 2008, the Fed has entered a late Brezhnev phase.

To rein in the Fed, it is necessary to impose a firm rule, mandated by Congress, that the Fed cannot violate without severe consequences. There are three such rules that plausibly might make sense: a nominal GDP target, a money supply increase target (probably based on M2) or an inflation target.

A nominal GDP target, first, suffers the same cognitive bias as the current unemployment target. Nobody is going to blame the Fed if growth is too fast, so the Fed has every incentive to pump up the money supply until nominal GDP is rising at a rapid clip, regardless of what happens to inflation (which is not being targeted.) The result would be even more extreme and damaging policies than we have seen over the last eight years, as the Fed attempts to push nominal GDP up to a satisfactory rate – you can see the problem in today’s Japan. The Keynesians at the Fed have not the slightest idea what causes productivity growth to stagnate, so a prolonged period of productivity growth stagnation, as we have seen, will cause them to overstimulate. Since this will push interest rates further away from their natural rate, and cause the Fed to invest even more in unproductive government and housing paper, there is every chance of a vicious cycle developing.

A money supply target, probably based on M2, makes more sense. The Fed started to go seriously off track when Alan Greenspan abandoned monetary targeting in 1993, and the total unconcern for rapid monetary growth has been a problem ever since. M2 money supply has consistently grown at around 6% per annum since 2009, even as nominal GDP growth has been barely half that. Even with three interest rate rises in the last six months M2 continues to grow at close to 6% – not surprising as real interest rates remain substantially negative. It is wholly implausible that with payments technology improving each year, monetary velocity has declined through natural causes over the last decade, yet decline it has, by more than 2% annually. Hence the velocity decline is artificial, and evidence of the hopeless distortion that has been introduced into the economy by Fed policies.

The problem with money supply growth as a firm target is that it can fluctuate unexpectedly, and the Fed can switch measures of money supply growth so that it is always “looking at” the one that is rising least. A money supply target, preferably based off M2, is better than no target at all, as we have now, but it is probably not optimal, even given the constraint of being forbidden to return to a Gold Standard.

Inflation targeting is popular, and since inflation rates are determined by the Bureau of Labor Statistics, they cannot be fiddled by the Fed itself. The problem is that both Japanese and U.S. experience has shown that too high an inflation target, even 2%, can result in prolonged periods of negative real interest rates. These are devastating to the economy because if the real cost of money is negative, then unproductive investment, if sufficiently leveraged, can yield a spurious profit.

There are far more unproductive investments available than productive ones, and it is far easier to find them and often easier to manage them than it is to do the hard work of seeking out and managing the often tricky productive investments in new technologies, for example. Therefore, an investment Gresham’s Law applies in this case, and unproductive investment drives out productive investment, becoming an ever larger proportion of total investment. The result is a productivity blight, as all countries that have used negative real interest rates have suffered since 2008.

If inflation is to be targeted, therefore, it needs to be targeted at a level that prevents long periods of negative real interest rates. Clearly, the ideal level to ensure this is zero. There is another reason why zero inflation is the most plausible target. Money is a measuring device as well as a means of exchange, so inflation in money values is as inconvenient as would be inflations in grams, ounces, gallons or feet. Those of us who lived through the 1970s know that adjusting all one’s arithmetic for a substantial and varying inflation rate is impossible, and the necessity to attempt such adjustment is highly damaging to business and personal decision making.

A 2% inflation rate is obviously less disorienting than a 10% inflation rate, and a 2% inflation rate that is a credible Fed target is less distorting than a 2% inflation rate that occurs by mere happenstance and could zoom up to 5% at any time. Nevertheless, even a 2% inflation rate will double prices for young people before they retire and, more damagingly, will double prices for 65 year olds if they live into their 90s — and correspondingly halve the value of their fixed savings and incomes. These costs are hidden, but they are not non-existent.

Setting a 2% inflation rate target allows the Fed to appear to be “stimulative” and therefore produces short term public relations and political benefits for it. Like most policies that produce short-term public relations and political benefits, it is thoroughly damaging in the long run, allowing unproductive investment to crowd out productive investment, inflating stock market and asset values beyond belief, and preventing people and companies from allocating resources based on a fixed measuring rod of money value.

The correct inflation rate target is zero. If some idiotic economists have convinced you that the BLS inflation figures are distorted, then do not adjust them with phony “hedonic” corrections, but go back on the Gold Standard. In the long run, we will all benefit.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)