Inflation and “Price Stability”

We still remember when sometime in the mid 1980s, the German Bundesbank proudly pointed to the fact that Germany’s y/y consumer price inflation rate had declined to zero. It was considered a “mission accomplished” moment. No-one mentioned that economic nirvana would remain out of sight unless price inflation was pushed to 2% per year.


CPI, annual rate of change. During the “stagflation” period of the 1970s, Congress enacted the Federal Reserve Reform Act and the Humphrey-Hawkins Act, which specified a list of miracles the Fed was supposed to perform.


The Federal Reserve Reform Act of 1977, which established the famous dual mandate, inter alia tasked the Fed with maintaining “stable prices”. It did not define price stability as perpetual debasement at some arbitrary rate. The Humphrey-Hawkins Act was adopted one year later and supplied precise definitions, goals and time tables. With respect to CPI, it stipulated that inflation was to reach 3% or less by 1984 and zero percent by 1988.

Not five, not four, not three, definitely not two or even one percent, but zero percent (the holy hand grenade of Antioch user manual illustrates that low single digit counting exercises sometimes require precise instructions).

We must interpose here that the pursuit of the elusive goal of price stability is impossible in any case and actually downright dangerous. For one thing, the so-called “general price level” does not exist. This does not mean that the purchasing power of money does not exist – it clearly does – but it cannot be quantified.

The biggest (and far from the only) problem is that there exists no constant that can be used for the purpose of measurement. Money and the goods and services it can be exchanged for are both subject to the forces of supply and demand – there is no fixed, unchanging quantity in sight anywhere.

Let us concede for argument’s sake that observing the prices of a fixed basket of goods over time can provide a rough idea on the evolution of “price inflation”. For reasons that have never been cogently explained, central bankers have changed their view of what constitutes price stability since the 1980s. These days they claim that an annual CPI inflation rate of 2% represents “price stability”.

Apart from this slightly Orwellian redefinition of stable prices, neither economic theory nor empirical evidence lend support to the idea that debasing money at this designated pace will foster wealth creation and economic growth. On the contrary, empirical evidence suggests the opposite.

For instance, under the gold standard that was in force during the so-called “Gilded Age”, consumer prices were actually in a mild downtrend. And yet, real economic output per capita in the US grew at a pace of more than 5% per year. Such growth rates have never been seen again since.


US real economic growth per capita during the Gilded Age – the four decades before the establishment of the Fed, when a gold standard prevailed and prices were actually in a mild downtrend.


The Gilded Age was blessed with the absence of a central bank and government spending that fluctuated between a barely noticeable 2 to 4 percent of GDP. Government was essentially a footnote in most people’s lives.


The Dangers of Pursuing Price Stability

In a progressing unhampered market economy prices should decline over time. After all, economic progress is characterized by growing productivity. Price trends should reflect the extent to which productivity growth exceeds money supply growth – which it generally does if gold is used as the genereal medium of exchange.

This effect can even be observed in today’s inflationary fiat money system, namely in industries exhibting extraordinarily strong productivity growth. It can also be seen that one of the arguments occasionally cited in support of deliberate monetary debasement – namely that consumers would delay purchases if prices were to fall – is clearly wrong.

The prices of computers, smart phones and countless other electronic gadgets have declined rapidly for many years – and yet, the industries producing such items are clearly thriving. In fact, their growth rates are generally stronger than those of other sectors. Computers have inter alia revolutionized manufacturing methods, and for quite a while productivity growth has accelerated economy-wide as a result (in recent years the effect may have begun to dissipate).


All economic central planning agencies are ultimately groping in the dark…


If central planners want to keep prices “stable” in such an environment, they have to push up the rate of money supply growth – which in turn requires suppressing interest rates and/or “unconventional” policies such as QE (i.e., outright money printing).

This will lead to the previously mentioned distortion of relative prices (see Part 2), and all the consequences it entails. The effects are inter alia visible in the form of recurring  bubbles in  financial assets and rapid growth in debt levels. However, money printing does not create one iota of real capital – it merely leads to its mispricing and misallocation.

The boom conditions accompanying an artificially induced credit and money supply expansion are therefore never sustainable. A bust will always follow, and usually the bust is a mirror image of the boom that preceded it. In a capitalist market economy there will still be net wealth creation over time, but the more often artificial booms are induced, the greater the structural damage to the economy will be.

This probably explains at least partly why economic expansions have become steadily weaker in the course of the post-war era. It also implies that the amplitude of boom-bust cycles will tend to increase – a phenomenon that could indeed be observed in recent decades.

The conclusion from this is that the price stability policy pursued by central banks is not a boon – on the contrary, it is a threat to wealth creation and prosperity.


Charts by St. Louis Fed, wikipedia




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One Response to “The Weird Obsessions of Central Bankers, Part 3”

  • Kreditanstalt:

    They DO love to quantify absolutely everything…it’s in the nature of Central Planners, who see themselves, their role, their activities and credentials as “SCIENCE”.

    The derivation of this strange belief – that “economics” is a “science”, with iron laws and unbreakable truths – goes back, I think, to the “Progressive Era” of the period ca. 1900-1920 and to the early 1930s “technocracy” and social movement-inspired efforts to defeat the Depression.

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