Targeting Inflation

New Fed Chairman Bernanke is on record as wanting to execute monetary policy so as to aim at some unspecified, positive rate of price inflation, although he promises not to unilaterally institute such a policy.

While we can be reasonably sure that he will not aim at a price inflation rate of 6%, it is not easy to understand the significance of much smaller rates.

The simplest way to understand price inflation rates is to roughly calculate the loss in the purchasing power of the dollar between the birth and the death of someone who survives to an age of 72 years.

Price Inflation Rate = Approximate Loss of Purchasing Power in 72 Years
______________ ______________________________

0.5% = 30%
1.0% = 50%
2.0% = 75%
3.0% = 87%
4.0% = 94%
5.0% = 97%
6.0% = 98%

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What Don is saying is that

What Don is saying is that your money will lose 87% of its purchasing power after 72 years of 3% price inflation, and 98% after 72 years of 6% inflation, etc. Another way of looking at it is to calculate the amount of purchasing power left in, say, $1000 dollars after 72 years:

0.5%: $697.05
1.0%: $484.99
2.0%: $233.49
3.0%: $111.57
4.0%: $52.91
5.0%: $24.89
6.0%: $11.62

And no, I don't know why my numbers aren't consistent with Don's.

Brandon, Your residual value

Brandon,

Your residual value numbers are clearer.

And no, I don’t know why my numbers aren’t consistent with Don’s.

My numbers were deliberately rough, but the problem is that your calculations were of the form .98*72 for 2%, when they needed to be (1/1.02)*72, for example, where '*' means 'to the power of'.

Regards, Don

This makes me so very, very

This makes me so very, very sad.

And the moral of the story

And the moral of the story is: don't hold long-term assets as cash.

Look at it another way. If Bernanke swore on his mother's grave that he would target a 1% rate of price level *deflation*, then after 72 years your purchasing power would double instead of being cut in half. Is that better? If so, then 6% deflation would be even better - after 72 years the purchasing power of your initial $1000 would be $64,000!! Heck, why stop there, why not target 10% deflation, or 20%?

That's absurd, of course (as in reducto ad). But if the dramatic erosion of purchasing power under even modest persistent inflation is as scary as Don's numbers make them out to be and thus is something to be avoided, wouldn't dramatic appreciation of purchasing power be something to be sought?

The answer is that the erosion or appreciation of the purchasing power of cash is irrelevant. Nobody holds cash for long-term investment - they lend it out to people who need it for short-term use or they invest it in capital.

What's relevant is whether people can predict the value of a dollar at some point in the future, so that they can assess the real value of an investment with some nominal-valued payoff. The easiest way to do that would be if dollars were constant in value for all time, i.e. if inflation and deflation were zero. But as long as the rate of inflation or deflation were constant, it could be any size and still allow money to be used as an intertemporal measure of value.

Practically speaking, inflation is never going to be constant no matter what the central bank's target is (even if it's zero). It's going to wiggle up and down unpredictably within a certain range; the best the central bank can do is try to keep it within a certain range and centered around a certain value. Price level changes would probably be most predictable if the inflation target were zero. But even a small-but-nonzero target would be about as easy to keep stable as a zero target.

So in short, I agree that zero inflation is best, but for a completely different reason: stablity and predictability of money's funtion as a measure of value rather than preservation of the long-term purchasing power of cash holdings. And while zero inflation is best, small and stable inflation isn't all that bad.

Are you suggesting that the

Are you suggesting that the difference between a 98% loss in purchasing power and a 99% loss in purchasing power is the same as the difference between a 5% loss in purchasing power and a 6% loss in purchasing power? Clearly, it is not. I don't think you can draw any conclusions from these numbers.

Eddie, Money is a commodity

Eddie,

Money is a commodity that is the most salable commodity at any given time and place, and is neither a store of value or measure of value. That money, by definition, can be rendered in an exchange ratio for almost any other thing, allows things to be measured against each other using money (whatever it is) as the common denominator. Keeping supply constant for whatever money you're using gives an absolute and clear view on supply and demand signals for every other commodity.

That bit of throat clearing aside, the natural state of industrial production is such that, ceteris paribus, "hard" money (commodity money whose supply is dictated by market forces and not fiat/whim) will naturally appreciate in value over time; for example, gold money is increased by mining processes, which are (except in dire circumstances indeed) going to grow at a much slower rate than general industrial production. If gold is your money, then everything relative to gold will increase, and thus prices fall (i.e. money appreciates / there is "deflation").

Steady price inflation via willfull monetary inflation reverses that process, and is essentially a tax on cash-holders; willful deflation (aside from 'natural' deflation due to production) would essentially be a tax on producers- either way the person or entity monkeying with the money supply in either direction is extracting value/rent from the economy.

As such active manipulation of supply distorts the information aspect of prices, it is generally a bad thing. If we must have monetary inflation, a neutral Friedmanite rule would be better than active management (ala index funds v. actively managed mutual funds), but it's still rent extraction nonetheless.

(look to the Mises institute to find works on why gold mining, due to the inflationary effect of the increase in money supply with gold-money, ultimately only returns the normal rate for mining- I'm at work so I can't look for the link).

However, what we don't know

However, what we don't know (and what is not captured in any of these measures) is how quality translates into price and what you can purchase for each dollar. Quality increases will reflected in higher prices in many cases, but CPI reflects that as "inflation". But surely that's not an erosion of purchasing power...

If your $1000 now is worth only $16.50 in 100 years, the sadness may be averted by mentioning that $16.50 buys a ticket to Mars that can get you there in 2 weeks; comparatively that's worth millions (as well as being impossible by current technology) so we're left scratching our heads as to how bad (if bad) the devaluation is.

eddie, The real problem is

eddie,

The real problem is that the FED exists to have a monetary policy. Prices in a market system are both motivators and signals that align the relative value of specific resources with the subjective values that consumers assign to the final products and services which employ those resources.

Whenever the government creates or destroys money or credit, or when it taxes or spends, it inevitably distorts the pattern of relative prices that would otherwise result from the desires of consumers and the actions of businessmen and entrepreneurs to best satisfy those desires. Government intervention cannot be neutral. Without government intervention, prices would change, but in relationship to supply, demand, valuations and human ingenuity. When things like computers, or food, fall in price due to improved engineering, competition, etc., other prices would tend to slowly rise in a dispersed fashion in the absence of a determined effort to inflate the money supply.

In the short run, it is the distortion of relative prices that is the primary negative effect of intervention. In the long run, saving is futile without a financial expertise in investing, whether innate, learned, or employed.

Regards, Don

Brian: As such active

Brian:

As such active manipulation of supply distorts the information aspect of prices, it is generally a bad thing.

On the contrary - a credible commitment by a central banker to maintaining a stable rate of price level inflation or deflation *adds* to the information aspect of prices, because it provides a more stable environment for economic actors to make intertemporal comparisons. It removes one dimension of uncertainty and noise when making plans that involve the future. If you believe such a commitment from a central bank, then you will know that a dollar ten years from now will buy the same amount of a broadly-defined and slowly-evolving basket of goods as it does today - if the central bank's committed inflation target is zero. If it's positive, you'll know not only that it will buy less, but you'll know how much less. If it's negative, you'll know how much more.

With commodity money, there are no such assurances. The value of gold (for example) relative to other products depends on the production cost of gold relative to other products (neglecting here for the sake of argument gold's non-monetary value). The gold price of land, labor, and capital is determined by the amount of land, labor, and capital it takes to produce gold. If the efficiency of gold production increases faster than the efficiency of production of all other products, then prices rise; if it increases more slowly, then prices fall.

Tell me: how well do you think anyone can predict the trends in gold production efficiency relative to all other production efficiency for the next ten years? The less well we can predict that, the greater the risk premium investors and lenders will demand - which means there will be fewer resources available for profitable investment and capital growth.

If we must have monetary

If we must have monetary inflation, a neutral Friedmanite rule would be better than active management (ala index funds v. actively managed mutual funds), but it’s still rent extraction nonetheless.

Friedman presented his rule as a counterpoint to the then-fashionable ideas of using monetary policy to target unemployment and output. The key insight of the monetarists was that actively managing money in that way is not only futile but harmful. Maintaining a constant money supply, or as Friedman grudgingly suggested, a constant rate of money supply growth, were proposed in hopes that such a rule would prevent policymakers from trying to control the economy through monetary policy.

"Stop trying to control the economy" is the right goal for monetary policy. But constant supply, or constant rate of supply growth, are the wrong mechanisms. Constant price levels or constant rate of change of price levels are the right mechanism.

Inflation targets constrain the central bank's discretion and thus their ability to try to produce non-monetary outcomes using monetary policy. Inflation targets restrict the central bank's concern to the domain of the value of money rather than macroeconomic variables that they have no true ability to control. Inflation targets are good, whether explicitly rule-based such as the Talor rule, explicitly adopted but with a discretionary implementation as Bernanke has suggested in the past, or merely implied as Greenspan is generally believed to have adopted as a de-facto strategy.

Don, Whenever the government

Don,

Whenever the government creates or destroys money or credit, or when it taxes or spends, it inevitably distorts the pattern of relative prices that would otherwise result from the desires of consumers and the actions of businessmen and entrepreneurs to best satisfy those desires. Government intervention cannot be neutral. Without government intervention, prices would change, but in relationship to supply, demand, valuations and human ingenuity.

By and large, I am of course in complete agreement with you concerning the nature of prices and the deleterious consequences of government intervention and distortion. You describe these things quite eloquently.

However: In my view, a central bank manipulating the money supply in order to maintain a small and stable rate of inflation is not harmful intervention. It is, in fact, the optimal policy for a central bank to adopt. The fact that there is a government monopoly on central banking is the harmful intervention that we good libertarians know must be there somewhere. But if we're going to have a monopoly forced upon us, we should at least be glad that it is following good policies (targeting price level) rather than bad ones (targeting unemployment and output).

I maintain that if there were not a government monopoly on central banking, competition would cause most central banks to adopt policies similar to the ones the Fed has been pursuing for the past decade or two, and that by doing so the banks would best serve not only their customers but also the economy as a whole.

A dictator that does the right thing is still a dictator (boo) but is still doing the right thing (yay). In this case, we're lucky that the Fed is doing the right thing.

Eddie has made me less sad.

Eddie has made me less sad. Thank you, Eddie.

And of course, when that

And of course, when that residual 2% that is left after a 72-year life at 6% inflation is passed on to the heirs, it will be subject to the estate tax, further reducing it. I don't recall seeing anywhere in the US Constitution anything about the government owning its subjects and all of their property.

Worrying about inflation in

Worrying about inflation in this way is like dreaming about the possibility of going back in time, taking $10,000 with you, and seeing what you could by during the Depression, for example.

Not an economist, but as I understand it, an economy with no inflation for an extended period is likely a stagnant economy.

What's worrisome is when "big minds" try to engineer a specific rate of inflation. It's not likely you can make one number better without screwing something else up.

Worrying about inflation in

Worrying about inflation in this way is like dreaming about the possibility of going back in time, taking $10,000 with you, and seeing what you could by during the Depression, for example.

The point of worrying about inflation is to realize that the purchasing power of cash is constantly being eroded. It's nearly impossible to use cash as a store of value over long periods of time. Over the long term, "money in the bank"... isn't. Thus, it makes sense to explore other options for keeping/growing purchasing power.

Greg, Not an economist, but

Greg,

Not an economist, but as I understand it, an economy with no inflation for an extended period is likely a stagnant economy.

This has no validity whatever. The primary driver of price inflation is monetary supply inflation. The secondary driver is likely the increased availability of credit over time that serves as a substitute for the demand for cash balances.

Working against price inflation are new and existing consumer products under the condition of ever increasing productivity. Also working against price inflation is an increasing economic population, as each new individual brings his own new demand for a cash balance.

Regards, Don

Jonathan, The point of

Jonathan,

The point of worrying about inflation is to realize that the purchasing power of cash is constantly being eroded. It’s nearly impossible to use cash as a store of value over long periods of time. Over the long term, “money in the bank"… isn’t. Thus, it makes sense to explore other options for keeping/growing purchasing power.

This is one of the many ways that monetary supply inflation serves the purposes of the central government.

The near futility of saving cash produces an increased demand for the government debt that allows government spending to exceed the already massive tax revenues that are collected.

Regards, Don

Greg P, The US economy had

Greg P,

The US economy had 50% deflation from 1800 to 1900 (i.e. sitting on your cash gave a 100% return over 100 years), and no one would say that the US economy was "stagnant" in the 19th century. We emerged as a major industrial world power.

Inflation is unnecessary and ultimately venal.