New numbers of the consumer price index sparked again a debate about what monetary policy can do to fight off European deflation and thence the economic glum across the continent. In brief, in February the HICP fell by 0.2 percentage points an an annualised basis. Since the average HICP is the ECB’s preferred gauge for „inflation“, this would suggest further loosening of monetary policy – not to mention that monetary
policy is as loose as it never has been, and this for years. So you may have noticed that I have put the term inflation in quotes, since inflation is something else, but not (really) the change of the HICP.
What is inflation?
The change of the HICP is just that, a change of the prices in a certain goods basket. This can at times be a rather good proxy for inflation, but it doesn’t need to be and right now it is plainly misleading. Let’s start with the word inflation. Its origin is the Latin word for „to inflate“, „inflare“, Germans would translate this to „aufblasen“. And the phenomenon of inflation is literally exactly what it says on the tin: an inflation. Recall that the real production level (usually proxied by the GDP) of an economy is calculated as the nominal level of production divided by the price level. Hence, the nominal production level is the real level multiplied with the price level.
Changes in the price level do in turn increase or decrease the nominal production level as compared to the real. In a manner of speaking, the price level „inflates“ or „deflates“ the real production level. Economists use the „GDP Deflator“ as a measure for inflation, the ratio of nominal and real production, again usually proxied by the GDP. The problem is now that we are talking about hard to measure magnitudes, so we virtually always use proxies. We proxy production by GDP and the price level by some goods basket like the HICP, which is fine most of the time but not always. The most dangerous mistake we (willingly and hopefully knowingly) make is to use a goods basket as an inflation measure that include prices of imports.
Here’s the crucial difference: Price changes of domestic goods that are required to clear a mismatch of supply and demand inside the economy is inflation/deflation. For example, if (as in normal times) demand exceeds supply, prices react to equilibrate the goods markets without changes to the real production level, still the nominal production increased, it inflated the real production level. That means that inflation/deflation is the overall shifting of prices within the domestic economy that brings about goods market equilibrium. We can measure a part of this phenomenon by looking at the price developments of a goods basket like the HICP.
By this reasoning it is clear why central banks aim at a low but positive rate of inflation as it is associated with excess demand, giving firms an incentive to expand production and meet the demand and in turn creating jobs or increasing productivity. Still, too high an inflation rate distorts the behaviour of consumers and firms too much. This kind of inflation is actually harmless and there is absolutely no reason to worry. All the same there is no reason to worry about short episodes of deflation, meaning only that there is excess supply and prices need to fall to clear the market. Falling prices tend to increase demand, meeting supply before the firms decide to lay-off workers or close factories. This waxing and waning of prices around an economy’s equilibrium is perfectly normal. Let me call these price movements equilibrium inflation.
… and what is it not?
On top of these natural price movements, there is monetary inflation/deflation, when the money stock grows too strongly or to weakly to keep up with the growth of the real economy. This reasoning is based on the notion of a quantity theory linking real production, price level, money stock and money velocity. A less-than-perfect development of the money stock may lead to another kind of price movements that is also usually called „inflation“. But this kind of inflation is, after the medium adjustments have taken place, just a nominal revaluation with no direct effect on the real production, apart from distortions due to the adjustments. Usually this monetary inflation, as I prefer to call it, is bad because it distorts the plans, expectations, nominal contracts and so on until the revaluation is over. By increasing the money stock by more than is warranted by the development of the real production, a central bank is sometimes able to increase demand, as people may be convinced to spend their money on basically anything before it loses value. This leads to all kinds of price bubbles, especially in assets such as housing (as a presumably safe haven for wealth) or stocks in the „search for yield“. Neither is healthy for an economy and creating monetary inflation is precisely not the way to stimulate an economy in a sensible way.
Then there is a third kind of inflation, let me call this external inflation (although it actually isn’t inflation in the sense above), since it originates from the foreign countries we trade with. Price levels also fluctuate when there is a mismatch in global supply and demand for goods, either imported or exported (abstract of exchange rates for now). Of these, only the price fluctuations of exported goods can be associated with a market clearing and all its benign effects. Import price changes reflect all sorts of market developments, from supply shocks due to weather or technology, geopolitical reasons to shifting preferences. However, these developments cannot be associated with the clearing of domestic goods markets, but with global markets. While equilibrium inflation is the direct reflection to a market mismatch and as such endogenous, external inflation is by all means exogenous and cannot be influenced by the central bank.
All these price developments are in the HICP numbers, the ECB’s preferred „inflation“ measure. To be blunt: the HICP is totally not up for the job. We should base monetary policy not on exogenous factors we cannot influence anyway. Take the latest figures for instance. In February 2016, the HICP of the whole of the Euro Area is down by -0.2 percent compared to a year earlier. There is a lot of talk since a couple of years of „how to get inflation back on track“. This is utter nonsense! We don’t want inflation „back on track“. We want less unemployment and more growth. Usually this leads to positive equilibrium inflation (but not the other way around!), which is still only a measure, not an instrument. Apart from this misconception of what central banks should do, also the proposed ways are totally crazy. From a higher inflation target and QE to helicopter money and NGDP targeting, it all aims at monetary inflation which would only distort the prices as scarcity signals, thus hampering the recovery.
Let me stress two points, first, central banks (by design!) cannot monetise away a liquidity trap, and second, recovery is about real magnitudes (jobs, production, purchasing power) and is as such a job for fiscal policy. Again, by their very design as the guardian of nominal magnitudes a central bank cannot influence the real economy (yes, I know, in the short term in can, but only up to a point and only around the equilibrium). If we want a recovery, the governments must finally act and pave the way, by removing red tape and investing in education and infrastructure. But loosening monetary policy further, because the flawed
measure of inflation is negative due to an external shock (oil price) will do only harm.