The Bear’s Lair: The correct inflation target is Zero

Jason Furman, in the Wall Street Journal, is just the latest former senior financial official (Chairman of the Council of Economic Advisors, 2013-17) to suggest the Fed should raise its inflation target above the current 2%. We know what these people want – a target high enough that rates can be reduced to zero again, below the rate of inflation, benefiting their rich friends with access to leverage. For the rest of us, there is only one proper inflation target: zero. Adopting that target would solve most of the economic problems currently plaguing the West.

In the days of the Gold Standard, there was no need for an inflation target. Interest rates were governed by the ebb and flow of the gold supply in each country – they were raised when gold flowed abroad, which rate increase then dampened incipient signs of inflation. Inflation depended on the world gold supply, which for constant prices needed to increase approximately as fast as world GDP, taking into account both population increases and output increases.

Large new gold discoveries, such as those at Ekaterinberg around 1820, California in 1849, South Africa in 1886 and the Yukon in 1896-99 caused an increase in the global gold supply and a period of inflation. Periods of industrial advance between such increases, such as in the early 1840s and the late 1870s, were often marked by quite a sharp deflation, with prices dropping up to 20%. Those deflationary periods could cause temporary depressions, because with the zero lower bound on nominal interest rates, real interest rates rose sharply as prices dropped; however, since there was no underlying economic disruption taking place, the recessions were short and the damage limited.

This attractive, self-regulating system was disrupted by World War I and the attempt after it to return to a Gold Standard at a parity that no longer made sense, given the wartime price rises and the accelerating global population increase. The result, after a speculative boom that could usefully have been restrained by higher U.S. interest rates, was a deep depression that through economic mismanagement lasted for almost a decade in several countries (though not in Britain, which was recovering from 1932). Most important, in 1933 President Roosevelt prohibited Americans from buying gold, thus making gold a political plaything of central banks and removing its ability to control inflation.

For the first quarter-century after World War II, the world was on the Bretton Woods standard, a fake gold standard that provided no automatic controls on inflation. Central banks set their interest rates ad hoc and governments set their budget balances ad hoc, but with no automatic controls, fiscal and monetary policy became gradually sloppier, ending in 1971 in the collapse of the Bretton Woods system and much higher inflation. The Fed made no real attempt to control inflation beyond the 1974 “Whip Inflation Now” buttons until the arrival of Paul Volcker in 1979.

Volcker made the first serious attempt to tackle inflation, and he did so by controlling the growth of broad M3 money supply. This worked very well, but it left interest rates higher than politicians liked, so when Alan Greenspan (Volcker’s successor) started dating the leftist journalist Andrea Mitchell, M3 control was abandoned. Just to ensure that it could never be revived, the Weimar Republican Ben Bernanke in 2006 abolished the reporting of M3 by the Fed – if you don’t measure it, you can’t control it!

Since inflation was still a problem, the next approach was to control it directly. The first attempt to do so was by New Zealand, in the 1989 Fiscal Responsibility Act, which provided for the central bank boss’s salary to be increased each year by 2% minus the rate of inflation – so if inflation exceeded 1%, he got a pay cut in real terms. This clever idea was abandoned fairly quickly but 2% became established as the “responsible” inflation target and was adopted in 2012 by the ineffable Bernanke. Since that time, the 2% target has been used several times by the Fed to justify ever further expansion of “stimulus” and zero interest rates, even at times when inflation has been perfectly well behaved around 1%.

By James Buchanan’s public choice theory, we can see there are very good reasons why politicians might want an inflation target of 2%, or even somewhat higher. A non-zero inflation target, plus substantial doses of “quantitative easing” allows the Fed in many circumstances to keep real interest rates negative, since there are no problems of principle in reducing short-term interest rates close to zero (rates below zero would bankrupt the U.S. money market funds or force them to extract negative interest from their clients’ accounts monthly, which would be politically unpopular).

This in turn allows the Treasury to run large Budget deficits, which can be financed mostly by the Fed at negative real interest rates, thus allowing the government to expand at no apparent real cost. The negative real interest rates inflate stock and real estate prices to infinity, thus allowing the politically influential (whether truly rich members of the “donor class” or mere senior denizens of the Uniparty – Pelosis, Bidens, McConnells) to leverage themselves using their political “pull” with the banking system and invest in assets that are more or less guaranteed to appreciate. Everybody that matters is happy!

That leaves the remaining 99% of us who don’t matter to the political class, for whom a 2% or higher inflation target is a very bad idea indeed. By raising asset prices through the roof, it prices the majority of people out of housing, and makes their retirement savings risky gambles on the merry-go-round never slowing. It raises inequality and thereby causes social division. Most important, it diverts huge quantities of investment into unproductive real estate and speculative ventures with a good story but no underlying reality (a criticism that many are applying to cryptocurrencies, for example). By doing so, it reduces productivity growth to a crawl, thereby making everybody poorer.

A zero inflation target avoids these problems. If the inflation target is zero, real interest rates will almost always be positive, and usually substantially positive. This will ensure that the “price of time” in Edward Chancellor’s phrase, is also always positive, so that the future trades at some discount to the present. This allows the economy to invest in a coherent, productivity-increasing way; indeed a negative “price of time” is economically absurd, since it assigns a positive value to delay and obstruction. A zero inflation target also deters governments from running ever larger budget deficits, which reduces the likelihood of a state bankruptcy that would plunge the national economy back into the 17th century, if not the 14th.

Finally, and most important, a zero inflation target allows people to plan their lives. It is quite impossible to figure out what income you will need in your retirement if you have no idea what money will be worth a decade or two in the future when you retire. In 1999, when lecturing to young colleagues in Croatia who were learning about capitalism, I defined “a million dollars and a house” as a sensible goal to retire comfortably for those without work pensions. If you are retiring at 65, let alone at the frequent Croatian retirement age of 60, that is no longer anywhere near enough – yet we have averaged only 2.5% annual inflation since 1999. The beauty of the Gold Standard was its absolute price stability; prices were lower in 1914 than they had been in 1819, when it was adopted. This gave Victorian personal finance a solidity it has always lacked since – thus “The Forsyte Saga.”

Given the lousy ethical standards of today’s governments, particularly the unelected bureaucrats, there remains one problem with a zero inflation target: the price calculators will fudge the figures, so that even if the zero target is attained, the value certainty of the Victorians will not be. My current “Quicken” personal finance management system contains 23 years of grocery bills, from which I can calculate that, since we are not eating vastly better than we were in 2001, grocery bills have increased by about 1% per annum more than official inflation. That is an unsurprising result; the official price figures since 1996 have contained a “hedonic” factor that includes an entirely spurious adjustment for Moore’s Law on computer equipment, suggesting that every doubling in processor speed doubles value, a laughable claim over a long period, since it makes a 2023 computer about 100,000 times as valuable as a 1998 computer. Thus, a zero inflation target, if we use official figures and they don’t fudge them further (always possible, alas) is equivalent to a 1% true inflation target. But then, a 2% target is really a 3% target, so its damage is even greater than I have suggested.

Bernanke obviously has nightmares in which he is riding a penny-farthing bicycle in an 1885 thunderstorm (the solid rubber tires lost traction on wet roads, and the additional height made you vulnerable to lightning strikes). Thus, he would have you believe that actual deflation is incredibly damaging and could be uncontrollable. That is nonsense. First, when we had deflation in the 1870s and 1880s, after the initial recession workers’ living standards increased steadily, because wages were sticky on the downside, so increased in real terms. (During that period, the U.S. had high immigration, which suppressed wages, but high tariffs, which tended to increase them – the economic policies thus roughly cancelled out.) Second, a zero inflation target would have the Fed indulging in Bernankeite levels of money printing if inflation reached say negative 3%, so any deflation would be very temporary and swiftly removed.

Money is a means of measurement, like a foot rule or a scales. It would be the action of a dishonest grocer to shrink the pound weight by 2% each year. The same is true of money; by targeting 2% inflation the Fed is as dishonest as the dodgy grocer and as damaging to its customers.


(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.)