We have discussed how these rules are useful a number of times in the past, especially important we always say is the ability these targets have for “anchoring expectations”.  After all, if we can anchor expectations of inflation then:

1. We can largely avoid relative price distortions from unexpected inflation
2. We increase certainty about the return on investment (by getting rid of purely nominal shifts for contracts without inflation adjustment)
3. We have the ability to strongly respond in the face of a crisis – as inflation expectations are anchored, firms are monopolistically competitive, and some prices are sticky we can use monetary policy to help boost underlying demand in a demand constrained economy.
4. As a result, fiscal policy only has to focus on the supply side of the economy and redistribution (unless we run into the zero lower bound, and the central bank isn’t allowed to print or buy assets to meet its targets).

However, for some reason this isn’t enough for people.  So lets look at the idea of expectation in a more public choice sense.

Governments don’t like us to know we are being taxed to pay for the treats we get given, some democratically elected officials are tempted to “monetize debt” in order to pay for it – its a silent tax!  To solve this, we give a central bank independence.  Ok, but the independence only exists in so far as the central bank is following a rule provided by government.  So we want contracts that help solve any possible “time-inconsistency problem”.  This is all fine and good.

So what should this contract be like?  Ultimately, the implicit tax appears whenever inflation is higher than expected – so when the central bank pumps in more juice than is consistent with the price setting behaviour of firms and households.  At first firms and households will be unsure if the extra currency is additional demand for their product/service, or for all products/services, so they will lift output/work … but once they see costs rise and once they see inflation itself is higher, they will respond by lifting inflation expectations.

This tells us that any extra output from breaking an inflation target, is only temporary, but the increase in inflation expectations will be permanent.  Again, this is one of our typical justifications … where does monetization come in?

Well the higher inflation also appears when we think about government bonds.  In money markets people ask for a nominal rate of return, based on expectations of inflation.  By increasing inflation past this level, we lower the real debt burden faced by government – they get a windfall, and the people paying for it are the people who lean’t to them.  However, this windfall is only temporary and ends up with higher nominal interest rates and higher inflation expectations (and realized inflation).

Government could commit to not doing this in two ways:  1)  Only sell inflation adjusted bonds,  2)  Have a central bank with an inflation target.

Here a credible inflation target also amounts to a commitment by government to not tax its citizens by stealth.

Inflation/price level/NGDP targeting (where we are targeting forecasts of the future) offers a clear and consistent way of dealing with the fact that we have a monopoly supplier of currency in a public choice sense, and it allows central bankers to manage the “demand side” of the economy IF we have appropriate information and an understanding of what is going on.  Getting a central bank to target “other things” outside of how they impact upon the forecast of inflation/price level/NGDP doesn’t make any sense.  [Note:  People weirdly seem to think that the Bank completely ignores them – this is completely wrong.  They focus on them as issues with regard to monetary policy, and all that information is captured in their inflation forecast]

If we think the “exchange rate is too high” ask why.  We might say the current account deficit has been high for a long time, but then why.  Well its high because the real exchange rate is high, and real interest rates are high – this tells us that domestic savings are too low … this has nothing to do with the inflation target of a central bank (as they do not control the long-term real interest or exchange rates) and everything to do with competition and fiscal policy in the domestic economy.  It is part of the “cost” of the policies that we have put in place as a society – so we should accept that there is a trade-off there, instead of destroying the RBNZ’s ability to do its job – as we have mentioned before.  Scott Sumner discusses this issue more here – and I think it is a fundamental confusion between the two that is creating so much noise in NZ at present.

However, all this debate reminds me of a speech by Bernanke back in the day.  The choice quote:

Although a strict rules-based framework for monetary policy has evident drawbacks, notably its inflexibility in the face of unanticipated developments, supporters of rules in their turn have pointed out–with considerable justification–that the record of monetary policy under unfettered discretion is nothing to crow about. In the United States, the heyday of discretionary monetary policy can be dated as beginning in the early 1960s, a period of what now appears to have been substantial over-optimism about the ability of policymakers to “fine-tune” the economy. Contrary to the expectation of that era’s economists and policymakers, however, the subsequent two decades were characterized not by an efficiently managed, smoothly running economic machine but by high and variable inflation and an unstable real economy, culminating in the deep 1981-82 recession. Although a number of factors contributed to the poor economic performance of this period, I think most economists would agree that the deficiencies of a purely discretionary approach to monetary policy–including over-optimism about the ability of policy to fine-tune the economy, low credibility, vulnerability to political pressures, short policy horizons, and insufficient appreciation of the costs of high inflation–played a central role.

Is there then no middle ground for policymakers between the inflexibility of ironclad rules and the instability of unfettered discretion? My thesis today is that there is such a middle ground–an approach that I will refer to as constrained discretion–and that it is fast becoming the standard approach to monetary policy around the world, including in the United States

“Constrained discretion” is (arguably) very much the flexible inflation targeting framework we use now – the determination to “fine tune” is one that is coming out increasingly, and is based on an illusion of understanding and control regarding the macroeconomy (that and a few fallacious ideas of how things have panned out ).

No-one is arguing against having a further look at financial regulation, and trying to understand what has happened there.  However, this provides no case for messing around with the way the RBNZ performs monetary policy and the existence of a floating exchange rate – and in their determination to “do something” there are a set of politicians, journalists, and other analysts/economists trying to take us down a dark path.

From what I can tell, the current debate about monetary policy taking place in the public makes little sense.  While I am sure we all mean well with our opinion pieces, the issues, the problems, the causes, and the tools aren’t really being discussed in a way that someone with an open mind can sit down and look at.  Sadly, I lack the time – and probably the ability – to give this a fair go.  As a result, instead I will just list down some things we need to keep in mind here.

David Parker has recently said two things which he used to justify the RBNZ scrapping inflation targeting, and moving to targeting a bunch of stuff:

1. The RBNZ needs to help exporters – as other countries are helping exporters
2. The RBNZ is to blame for our “persistently high exchange rate”

I discussed a similar post of his earlier.  But right now, I want to state that neither of these things is really true – I can 100% understand how someone could come to believe this given what we see going on around us.  However, they aren’t facts – they are fallacies.

Note:  He does mention “protecting financial stability to help exporters” – this statement doesn’t make sense.  The RBNZ does focus on financial stabilty in a seperate role, and with seperate tools – a role that is related to, but seperate from monetary policy (just like fiscal policy).  In none of this is, or should, the RBNZ look at a certain sector in NZ and say “we’re giving you stuff” – that is just wrong.

Sidenote:  If you say “but helping exporters with monetary transfers helps all of us” I will laugh – if NZ goes down that path, I look forward to having my views vindicated in 20 years time

Country exchange rate fiddling?

It turns out that other countries are not helping exporters (apart from some developing nations).  The US and Europe are all involved in Quantitative Easing – which is a form of monetary policy.  We discussed this issue here and here.  QE is not “beggar thy neighbour”, it is an easing of monetary policy because domestic demand conditions in the country are too tight!  If we call this currency intervention, then we should call cutting the official cash rate, or increasing government spending, currency intervention as well!  

Note:  To make it clear, the view is that a high exchange rate slows down a recovery here – however insofar as this happens, our own central bank keep interest rates lower as a result.  As long as QE is consistent with their monetary policy mandate, the countries are not involved in trade protectionism, they are trying to make up for a shortfall in demand.  If anything this is more likely to boost demand here, and boost incomes through commodity prices – implying that arguing against it is arguing against what is in our intereset.

Central banks are not breaking the rules, this isn’t a prisoner’s dilemma – competitive devaluations HELP when demand is suppressed … just look at the Great Depression, and the choice of countries to go off the gold standard!

Persistent overvaluation?

When it comes to the “persistently high exchange rate” we can well point out that there is an issue, – not the nominal exchange rate, but the persistently high real exchange rate.  While a lift in our terms of trade should increase the real exchange rate, the constant current account deficits suggest there is in fact something going on.

However, a persistently high real exchange rate isn’t the fault of monetary policy and the RBNZ.  A persistently high real exchange rate tells us something structural is going on in our economy – it could be a sign of a government sector that is “too large”, poor domestic competition, a excessively low savings rate relative to investment opportunities in a country, or some mix of similar issues.  As a result, this has to do with competition policy, tax policy, government transfers, and the allocation of government services – but nothing to do with the Reserve Bank keeping price growth at 2%pa.  Remember, it isn’t just an issue of too much credit being offered – but too much being borrowed by people domestically who wish to investment and consume.

Remember the exchange rate is a price – it is a “signal” of real imbalances rather than the cause.  Remember, it hasn’t been the “consumption” of cars, TV’s, and baseballs that has been excessive – it has been our “investment” in housing stock prior to the crisis.  Remember that working for families was a large transfer to the middle classes – which helped to smooth income inequality, but also would have pushed up house prices and could have lifted the real exchange rate by increasing demand for non-tradables … in fact the more effective the programme has been, the larger this impact would have been.  I’m not saying that we should reverse these policies – I’m just saying that we should ADMIT they have a broader cost in terms of efficiency, one the government conveniently ignores when it markets them!

Blaming the central bank for this issue involves ignoring the actual causes of the imbalance – for a politician it involves standing up and saying “I want someone else to deal with the problem I’m partially responsible with creating”.  In that sense this is poor.

As a result, when we enter this debate let’s ask “what is the cause of NZ’s high real exchange rate” and “does the RER indicate a “market failure” or “government” failure somewhere within the NZ economy”.  These are the fruitful questions – not arbitrary attacks on the Reserve Bank.

Update:  Good article by Brian Fallow.  I don’t agree with everything in it 100% (flexible inflation targeting is occurring in a lot more places than Aus and NZ – and QE is not “beggar thy neighbour” policy), but it is an excellent discussion of the state of play – and the fact that other policy makers need to take responsibility!

For a starting point, lets not make the mistake of comparing inflation targeting and NGDP target – one is a growth rate and one is a level.  The relevant comparisons should be inflation target vs NGDP growth target and price level target vs NGDP target.

The primary difference between a growth and level target is whether a central bank can “ignore past mistakes”.  If we assume that can we compare growth targets – otherwise we set a level target.  We choose growth usually, because we are focusing on expectations of the future – including past mistakes explicitly would muddy the water, and make central bank actions less credible.

So what is the difference between targeting a growth rate in prices (inflation) and a growth rate in NGDP (nominal income)?  The growth rate in prices is the inflation thing we have justified in the past – the growth rate in nominal income is a composite of higher quantities of production and higher prices.  An inflation target aims to get price growth to sit around a certain level over the long term, an NGDP growth target aims to get price level growth to sit around a certain level over the long term … the reason they do the same thing is because real growth in output in the long is “exogenous” – it is independent of the fiddling with monetary variables.

As a result, the entire difference in the target boils down to its short-run dynamics.  In the short-run, due to sticky prices, money illusion, and a whole host of psuedo-psychological explanations, there is a trade-off between inflation and unemployment … and as a result inflation and output.  Now when there is a shock, an inflation target gives us a clear path to what is going on – we respond such that inflation is back at target.  NGDP growth targeting gives us a mixed message – we will respond such that inflation*output equals our target.

Although the long-term “inflation target” is clear in NGDP growth targeting, the short-term target is not … especially if private actors can’t differentiate between “supply side” and “demand side” shocks, and so are unsure whether monetary authorities will essentially tighten policy (in the demand side case) or loosen policy (in the supply side case) after seeing the price level jump.  Now the same visual asymmetry exists with inflation targeting (due to the difference the between the shocks) but a central bank at the moment can credibly say that the change in price is in the past – and in the future the price level will grow by X%, anchoring expectations and aiding price setting.  Furthermore, it is credibility that allows the Bank to anchor expectations, and with expectations anchored this allows them to limit any deviation of output from its “natural rate” through their interest rate setting.

In the case of NGDP growth targeting, there is no anchor to a real choice variable – nominal income is something we see, but it is not the choice variable people use, like output or price.  As they can’t tell what the central bank is doing regarding a target for price or output, expectations are unclear, and there is likely to be unnecessary volatiliy and misalignments solely due to the choice of target.

Now of course there are arguments both ways – but expectations formation is the major issue to keep in mind when we think about these things.  And I’m not convinced that NGDP growth targeting has an advantage over inflation targeting here.

But what about level targeting!

Although level targeting has the disadvantage of making expectations unclear, it has an advantage during a liquidity trap.  However, a credible central bank could insert a clause in their policy target agreements that states what a liquidity trap is, and gives them jurisdiction to temporarily increase the inflation target in this state.  Problem solved.

Yes, central banks don’t seem to be responding (although I would suggest that QE is essentially the Fed stating that it will violate its target in the future) but I’d put that down to the lack of clear vision regarding whether this is a liquidity trap – it also doesn’t help that European authorities are clinically insane … I think if you had put that in the Fed’s forecasts they would have eased more aggressively.

Another advantage of level targeting is that it increases long-term certainty about the price level (both price and NDGP targets – as long run RGDP is exogenous remember ).  Overall though, NGDP suffers from the same expectation issues in the short-term that NGDP growth targeting would.

Summary

If I had to summarise what I’ve said to an economicsey auidence, I would say that I’m not convinced that NGDP growth targeting offers a superior alternative to “flexible” inflation targeting, even if both involve commitment to a state-contingent policy plan for the Bank (plans which have their advantage by informing public expectations).  The inflation target has the advantage of communicating a clear path for the price level, and it remains consistent even as the underlying rate of RGDP growth changes.

Now, as readers of TVHE you have seen past this rouse, and you recognise that monetary policy is independent cyclical policy that is intended to ensure that “inflation” stays at a certain rate and that shifts in output due to “aggregate demand” are kept to a minimum.  Again, this is a simplification – but it gives us our role, something we have discussed in more detail here. [BTW, there is a good post on discussing the right practical target variable here].

When thinking about what real inflation is we get to the point that “inflation” is very much driven by expectations.  As a result, the goal of the monetary authority is to anchor inflation expectations!  This is exactly the point made here, and it is true – Chuck Norris and the central bank have a lot in common.

When we understand this, we can get an idea of what to do when we are in a liquidity trap.  Simply put, say you are going to violate the target and target a higher level – or find a way to commit to it if needs be (thereby getting those real interest rates down – something that has been forgotten recently).  There is wide agreement among economists on this from the left and the right, and yet peoples refusal to look at monetary policy in this frame is stopping society from putting in place the correct monetary policy/framework.

However, we can also get an idea of the real issues in monetary policy – do we really understand how expectations are formed?  Do we really have a way of measuring commitment by a central bank?  Do we get commitment of the target, or of the institution, when we do this?  Even so, it is off this true base of understanding that we can analyse the issue – instead of the ad hoc and patently ridiculous things that are written about monetary authorities a lot of the time.

Note:  Good post here discussing monetary policy in terms of expectations and co-ordination – good links at the end as well.

First, spending and pricing decisions are assumed to be based on long-term assessments of real income and real rates of return. Second, changes in monetary policy can only change real interest rates temporarily. Ultimately, the forces of productivity and thrift determine them, not changes in nominal magnitudes on the central bank balance sheet. Combining the two propositions implies that the Federal Reserve’s interest rate policy, as long as it stays within the narrow range of experience, would not be expected to have a significant or long-lasting imprint on markets or activity.

This is a great result.  It suggests that the central banks ability to change the “structure” of the economy, or make any long lasting changes to economic conditions, is negligible.  Without any “long-run costs” of Fed policy this suggests that monetary policy CAN be used to stabilise activity in the very short run – so it reforces the view that a central bank should look at “smoothing the economic cycle” by keeping underlying inflationary pressures near a certain target.

This is consistent with the orthodox way of viewing monetary policy.  However, interestingly Arnold Kling states that this paper is something he agrees with, but it “puts (him) at odds with Scott Sumner and John Taylor, among many others.” – people who are also part of the orthodoxy.

I believe that the issue here is that people are talking past each other a little – in terms of strict monetary policy, the views that Scott Sumner and (originally) John Taylor focused on were short-run, and as a result they were interested in the stabilisation role of monetary policy.  Kling appears to have ignored the idea of the short-run to focus on the relevant view of the long-run – something we can’t do in the face of price/wage stickiness.

Now I agree with Arnold that many people give the idea that central banks can create miracles FAR too much weight.  I think that central banks should not be involved with structural policy, or if they are it NEEDS to be separated from their stabilisation role for the sake of transparency – but this issue is separate from the focus on thinkers like Sumner.

Still, there has been a lot of banging on about the carry trade and mortgage rates, and I think some of it stems from a little confusion regarding shifts and movements.  As an example I’ll work with this post from the Standard (ht BK Drinkwater).

Note: This is being added to the inflation debate, as a discussion of interest rate determination in a small open economy.  Starting from the bottom, the combination of posts under that tag gives a fuller idea of what we are talking about with inflation targeting and our (narrow) view of monetary policy.

Let us start with the facts.  There has been a carry trade.  We have had relatively higher interest rates then most countries.  There was a housing bubble.  Our currency did appreciate above historic norms.  We did have high capital inflows.

No-one disputes these facts.  However, recently people (mainly associated with Labour) have been putting them all together and saying “Aha! The Reserve Bank has caused all these things by lifting the OCR”.  However, once again the gap between correlation and causation has struck.

Now over the past decade we haven’t just experienced a change in the official cash rate.  Asian nations have begun saving like crazy, they have built up reserves to lower their currencies.  Furthermore, the US has run a “strong currency program” while keeping interest rates low – which in essence is just saying that they have allowed other countries to peg their dollar at an artificially low level.

Furthermore, unrealistic expectations regarding house prices in developed economies combined with easy credit overseas saw house prices climb to levels that did not seem (and in the end weren’t) sustainable.

These factors “shifted” the demand and supply curves for credit in New Zealand.  A belief that house price appreciation was sustainable (combined with the tax treatment of housing) saw demand for credit rise.  Easy credit availability from overseas increased the supply of credit at each and every interest rate – implying that the supply curve also “shifted”.

So what about the OCR!

The official cash rate has some ability to change domestic interest rates, by changing the opportunity cost of borrowing/lending from the RBNZ.  Using this mechanism the Bank can cause a movement along the demand and supply curve.  In the end, the quantity of credit equal the smaller of the demand or supply of credit at that interest rate.

Now conceivably, if we have a shortage of credit (given demand) an increase in the OCR could increase the quantity of credit by moving us up the supply curve.  However, New Zealand is special.

New Zealand is a small open economy – implying that we have access to an infinite (as much as we can eat) amount of credit at the world interest rate. This implies that the carry trade argument is IRRELEVANT for NZ!

As a result, ALL that matters is the demand curve.  As long as demand for credit is falling in the domestic interest rate (so people borrow less as the interest rate goes up) then a higher OCR does reduce these capital inflows we have randomly become scared of.

As this is a more than fair assumption, I’m sticking with it.

But people did borrow more, especially in housing!

Yes they did.

And we should be asking why people borrowed more.  What structural factors have driven the imbalances in the New Zealand economy?

Ultimately, monetary policy in its essential form (targeting inflation) has served us well.  However, other “shifts” in the domestic and international economy have caused issues.  Instead of attacking one of the parts of the economic establishment that is actually working we should be trying to figure out what parts are broken!

Update:

I wrote this on Friday and published it on Tuesday.  Since then I have seen this quote from the Standard:

Our current setup is causing the housing bubble, the high currency, and the current account deficit.

That is exactly the error in thinking I mention in this post.  Don’t get me wrong this is an incredibly common error, and plenty of very intelligent people have gone down this track.  But we DO NOT have causation just because some numbers run together.  This is the problem with looking at data without having a coherent logical model in mind.

Also note that I have nothing intensely against the mortgage interest levy – I just think that if we had a tax system that treated assets equally there would be no need for some arbitrary other tax …

When inflation was scaring all of us in NZ we did a series of posts under the “inflation debate” tag.  For more detail on the issues that is a good place to have a little look.

Now fundamentally, an economy is all about REAL goods and services flushing around, things people value and create.  Money only matters insofar as it provides some sort of benchmark that allows us to compare the RELATIVE VALUE of different goods and services.

In the LONG RUN (the period over which all prices can move freely) the relative price of goods and services are indicative of the relative value placed on these goods and services in society and money is said to be neutral.  In this case, monetary policy is something that just doesn’t matter.

Where monetary policy does matter is in the SHORT RUN (when some prices in the economy cannot, or are costly to, change).  In the short run an economic shock may lead to relative prices changing even when there has been no real change in their underlying value, and monetary policy can help to improve matters in this case.

In order to ensure that any “nominal shocks” do not occur, monetary policy has been given POLITICAL INDEPENDENCE (so that politicians cannot try to move things around to win elections) and an INFLATION TARGET.  The purpose of the inflation target is that it allows people to know how much prices will generally change, which informs their expectations when they set prices and make transactions, and which therefore leads to the relative price of goods staying where they should be.

The key thing here is maintaining expectations of inflation at a level that the Bank is targeting.  It does this by setting the opportunity cost to banks for borrowing from or lending money to the Reserve Bank – this is called the official cash rate.  By doing this, the Reserve Bank (in conjunction with some prudential policy) can change the interest rate, which in turn changes peoples incentives about whether to borrow or save now.

If we have experienced a nominal shock which leads to general upward pressure on prices, the RBNZ can increase the cash rate and exert downward pressure on prices.  By doing this, the Bank shows that it aims to keep the general growth in prices at a certain level, and people form expectations of price growth on this basis.

This is the purpose of monetary policy, this is all it is supposed to do.  By making the general change in prices transparent they make it easier for everyone in society to make informed decisions.  From there the allocation of resources depends on the incentives of private agents, which are determined by real factors and any biases stemming from institutional or fiscal organisations.

But what about the exchange rate, and the tradeable sector

In the long run the exchange rate does not matter – it is just some relative value of two currencies, which is based on the relative price of goods (and the cost of transportation) between the nations.  In the long run the price of tradeable and non-tradeable goods will change such that the value of the currency is inconsequential.  Again any concern stems from the short-run.

However, as long as we are focused on ensuring that inflation expectations are “anchored” there really is no point looking at monetary policy.  Why?  The exchange rate is a relative price, not a general price level – monetary policy deals with the general price level, not individual prices.

When we put it in these terms, we realise that IF the NZ dollar is persistently over-valued (or if we just think that the swings are too big relative to the change in the world price of goods) there must be an actual structural reason for that.  The question should be “why is our dollar behaving like this” and “is there a net welfare improvement available from changing policies/institutions that have put us in this position”.

Well what is happening?

As we said here the factors we could point out are:

1. Other countries are trying to suppress the value of their currency (as suggested here, here, here, and here),
2. Households and businesses are taking on too much debt,
3. Government policy is creating a wedge between the private and social benefits of individual actions.

Each of these specific factors may create a real dislocation, and have real welfare consequences for New Zealand.  If it turns out that we do believe any of these factors are at fault, then we could come up with policies to deal with them.  Arbitrarily attacking the monetary policy framework, which has created certainty around changes in the general price level (note that no-one can remove the uncertainty from changes in relative prices – so the Bank cannot be blamed for that) is just silly.

James Hamilton at Econbrowser pointed to a paper by Reis and Watson which points out just how essential this difference is in a “low inflation environment”. The money quote from the abstract for me:

We find that pure inflation accounts for 15-20% of the variability in inflation while our aggregate relative-price index accounts most of the rest.

The pure inflation mentioned above is the fundamental increase in the general price level we often complain about as economists. “Inflation” in this paper is growth in the private consumption expenditure deflator (which is similar to the CPI – except that the bundle of goods is not fixed).

Now we don’t want to try and prevent relative price shifts – as that is the whole purpose of the price signal. So understanding this distinction is important. Very interesting.

Update: I don’t think I was clear enough on where I think the value is here. The paper seems to indicate to me that movements in the CPI and PCE deflator are relatively poor indicators of the magnitude of any change in inflation. This is a very good point, and I love it that this paper was able to mince the data up and show this.

Update 2:  Paul Walker blogs on a pre-release of the paper here.  Paul concludes:

They found that once they controlled for relative price changes, the correlation between (pure) inflation and real activity is essentially zero

That is true.  But let us be clear here, this implies that there is no money illusion (which economists currently assume), and so all quantity issues stem from nominal rigidities in prices (which we have discussed).   As a result, even pure inflation is still costly, as nominal rigidities exist causing a mis-allocation of resources (since relative prices get messed up).

Another interesting conclusion in the paper is that the rigidities in the labour market aren’t as strong as we would expect.  If this is shown to be the case over time it would change my implicit view of the economy.  Man I wish I could do a study like this for the NZ economy

Now Barry Ritholtz points out another interesting point from the piece – their discussion of the fact that house price growth was effectively taken out of the CPI.  The money quote is:

If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%. With nominal interest rates around 6% and inflation around 6%, the real interest rate was near zero, so household borrowing took off.

Let’s discuss.

As an economist I get told all the time that the CPI understates “inflation” as it doesn’t include house prices.  My answer is always the same – CPI isn’t a measure of inflation, it is a measure of the growth in consumer prices.  Now housing is partially an asset and partially a consumption good.  The CPI includes a “rental-equivalent” value to take account of the consumption good – while the asset part is left out.  This makes sense for what the index is intended to measure – namely growth in consumer prices.

Inflation on the other hand is a peverse increase in the general price level of the economy – not an increase in the price of an asset, or a food type, but a consistent increase for no real reason other than it just does.  Given the rigidity involved with changing SOME prices, and given the cost of changing prices, this process is costly – and we would like to have an economy where we can pull this sort of process out.

In the long-term inflation has nothing to do with rising consumer or housing prices persee – inflation stems solely from permanent increases in the money stock.  However, in the shorter term, inflation is a wilder beast – and given that we care about it over this time horizon (as it influences planing and purchasing decisions) it is something we need to understand and battle.

Now, over the “medium-term” the primary driver of inflation is inflation expectations – as the “velocity of money” doesn’t have to be constant, so if society expects inflation it can make it happen, even if the money stock is fixed. (My views on inflation and price indicies can be found in more detail on this set of posts)

In this case we could ask – what were inflation expectations like in the US.

Source St Louis Fed

As we can see, inflation expectations weren’t as high as the “inflation” that was complained about in the article.  As a result, I do not believe that underlying inflation (which is near on impossible to measure ) was that high either.  Fundamentally, people were making decision based on a belief that inflation was close to where the Fed believed it was – not where an index including house prices would say it is.

Taking this we have to ask – what the hell does rising asset prices have to do with anything.  The answer is a lot – but not by “being inflation”.

Asset price rises and wealth expectations

The rising house prices were a concern as household’s confused them for real wealth – and spent accordingly.  As a result, household’s consumed at an unsustainable level.  Now that they have realised that they want to, and need to, pull back.

This is similar to the “real interest rate argument” that was made – however, it makes the channel through which the problem occured more transperant.  Framing it this way implies that the crisis may not have been the result of “interest rates being too low” – it may have instead been that there was some simple issue with the way people were forming expectations.  I blame FOX news

Here the underlying issue is not one of “inflation” and its damaging consequences to relative prices in the economy.  The underlying issue is “households expectations” – which fell wildly out of whack with reality.  In such an environment, the US and NZ both invested heavily in consumption infrastructure, while China invested in production infrastructure.

The shock of falling house prices has seen consumption slump in the highly indebted countries, causing some of this infrastructure to become both sunk and worthless.  In this case, the world economy must go through a costly readjustment – and policy cannot help directly.

As mentioned before though, the idea that keeping inflation expectations (and to some degree consumer price growth and other price growth) positive is essential.  By doing say, we lower the real interest rate – helping to ease the transition path of the readjustment (although we must be careful not to screw up the relative price signals associated with the change in economic structure).

But more importantly IMO – we help to reduce real wages.  In the labour market, the demand for labour internationally has just taken a hit.  Given that it is difficult for nominal wages to fall, getting real wages down (through inflation) is key in order to prevent even sharper increases in unemployment.  Ultimately, if real wages don’t fall, more people get laid off – that is the way it is.  The more people that get laid off, the more production and therefore income falls, which implies more pain for society. (Discussion here)

Conclusion

The asset price increase from housing SHOULD NOT be counted as inflation.  However, the fact that it happened IS important for policy and forecasting.

The seperation of “inflation” and “asset price increases” is very important for diagnosing what the problem is – and how policy might be able to help improve outcomes.  As a result, let us all try to keep this difference separate – so that we can truly figure out what needs to be done, what pain we are stuck with, and if there are any institutions that need changing to improve outcomes in the future.