Download Inflation Targeting and The Need for a New Central Banking

Inflation Targeting and The Need for a New Central Banking Framework
Mevlut Tatliyer
Department of Economics and Finance, Istanbul Medipol University, Istanbul, Turkey.
Mail Address: Kavacık Mah. Ekinciler Cad. No.19, Beykoz, Istanbul, Turkey,
Tel: +902166815100.
E-mail Address: [email protected].
ABSTRACT
This paper critically analyzes inflation targeting (IT) in both theoretically and empirically. IT
came into prominence in the 1990s and one central bank after another adopted this regime in
the 1990s and 2000s. Proponents of IT mainly argued that IT regime was successful on the
grounds that it resulted in lower inflation rates and hence better economic performances.
However, inflation rates in the world were in a downward trend from 1980s well into 2000s,
and both IT and non-IT regimes managed to decrease their inflation rates. In addition,
focusing too much on price stability through IT paved the way for permanently higher than
necessary interest rates and disinflationary “tight” monetary policy periods when inflation rate
was above an arbitrarily targeted level. Tight monetary policy can and do affect the real
economy negatively and overemphasizing price stability may hurt the economy in terms of
lower potential output, decreasing investment and more unequal income distribution. Our
main conclusion is that central banks should adopt a new monetary policy framework.
Key words: inflation targeting, monetary policy, disinflationary process, threshold inflation.
JEL: E31, E52, E58.
Introduction
After the collapse of the Bretton Woods system in the 1970s and the rise of the neoliberalism
in both political and academic spheres in the 1980s, a new consensus among mainstream
economists has emerged and monetary policy and central banking both in theory and in
practice have significantly evolved in tandem. This new consensus was heralded by several
economists including Blanchard (2008), who stated that
after the explosion (in both the positive and negative meaning of the word) of the field
in the 1970s, there has been enormous progress and substantial convergence. For a
while -too long a while the field looked like a battlefield. Researchers split in different
directions, mostly ignoring each other, or else engaging in bitter fights and
controversies. Over time however, largely because facts have a way of not going away,
a largely shared vision both of fluctuations and of methodology has emerged. … The
state of macro is good. [p. 2. Italics added].
In the new discourse, the transparency, independence and credibility of the central banks have
been highlighted and significantly praised, and starting from the 1990s, inflation targeting
(IT) as the major, if not sole, monetary policy goal has been commended by both mainstream
economists and policy-makers (see Goodfriend, 2007; Woodford, 2009).
However, this new monetary policy framework did not go uncriticized on different grounds,
particularly after the 2008-9 global financial crisis (see Arestis, 2011; Arestis & Sawyer,
2010; Fontana & Palacio‐Vera, 2007; Lavoie, 2006; Svensson, 2003). One of the main
criticisms directed at this paradigm is the overemphasis of both price stability and inflation
threat, and the resulting negative economic consequences of it, such as higher unemployment
and lower economic performance (see Davidson, 2006; De Gregorio, 2012; Fontana, 2009a;
Lim, 2008; Rochon & Rossi, 2006).
The Bretton Woods system, which had been in place from 1940s to 1970s, was characterized
by, inter alia, fixed exchange rates, restricted international capital flows and caps on interest
rates. Moreover, mainstream attitude towards inflation in this period was informed by both
Keynesian demand side economics and the embracement of the Phillips curve paradigm. In
this period, mild inflation -far from being a threat to the economy- was seen beneficent to
economic growth and employment. Therefore, under this system, the main objective of the
central banks were the maintenance of the fixed exchange rates and central banks had had no
need or much room to implement a full-fledged monetary policy, as Goodfriend (2007)
indicated that
[f]rom the perspective of monetary economics, a central bank had little need to
communicate with the public under a gold standard, as long as it faithfully maintained
a fixed currency price of gold. [p. 23].
However, everything changed when the Bretton Woods system collapsed and was replaced by
the neoliberalism paradigm. Fixed exchange rates were replaced by floating exchange rates,
caps on interest rates were removed, restrictions on international capital flows have been
discarded and financial system has been deregulated almost entirely. Thereby, the tools at
central banks’ disposal in the implementation of the monetary policy have become much more
diverse and central banks have become much more potent. This is -probably- why central
banks and their presidents in all over the world have been much more infamous from 1980s
on than those under the Bretton Woods system were. Think about infamous Fed presidents
Paul Volcker (1979-1987) or Alan Greenspan (1987-2006) against not-so-infamous and then
largely invisible Fed Presidents William M. Martin (1951-1970) or Arthur F. Burns (19701978).
Not only economic structure of the world in this period evolved dramatically, but also
mainstream economic understanding changed significantly in the spirit of neoclassical
economics in the 1980s in line with the rise of the neoliberalism. Alongside the removal of the
Keynesian demand side policies, fiscal policies largely fell out of favor and a hands-off
approach to the economy started to reign over in this period for mainly ideologically driven
unpopularity of fiscal policy among mainstream (neoliberal) economists as revealingly
pointed out by Goodhart (2005):
[T]his is symptomatic of a deeper reluctance among macro-economists to conceive of
any essential role for government. They seem intellectually happier to imagine an
economy which is only inhabited by private sector agents and an ‘independent’
Central Bank with its own loss function (and no mandate from, or acceptability to, a
democratically elected government). [Quote obtained from Fontana (2009b)].
On the other hand, once being the promoter of the economic growth and maintainer of the full
employment, central banks started to be seen as maintainer of the price stability via only very
low inflation rates, which was allegedly achieved almost only by interest rate policy as
revealingly indicated by Goodfriend (2007):
[T]hinking about monetary policy as interest rate policy is one of the hallmarks of the
new consensus that has made possible increasingly fruitful interaction between
academics and central bankers. [p. 21].
Thereby, IT started to spread to all over the world. Starting with New Zealand (1990) and
Canada (1991), one by one, first industrialized countries in the 1990s and then developing
countries in the late 1990s and early 2000s embraced this regime, such as Korea in 1998,
Brazil 1999, Hungary in 2001 and Mexico in 2002 (Batini & Laxton, 2007).
In parallel with all these, much importance started to be given to the independence and
credibility of the central banks in this period. In the end, central banks gained significant
autonomy in the implementation of the monetary policy, which, in turn, has mostly been all
about interest rate setting and inflation targeting.
While new central banking framework and IT have been exalted significantly that they
allegedly culminated in lower inflation rates and better economic performances, the empirical
evidence for the vindication of that stance seems at best weak, and mostly mixed or none.
First, now it is clear that there is no compelling evidence that IT countries have had lower
inflation rates than non-IT countries. In addition, the evidence that inflation rates of the
several countries started to decline before the IT regime was adopted increases doubts
regarding the value of this regime.
In the first years of the IT regimes, although it was too early to have an ultimate idea
empirically over whether IT is working or not, scant evidence allegedly showed that it worked
as Neumann and Von Hagen (2002) expressed:
Taken together, the evidence confirms the claim that IT matters. It has permitted IT
countries to reduce inflation to low levels and to curb the volatility of inflation and
interest rates. … Thus, IT has helped the former high-inflation countries to gain the
credibility. [Italics added].
And to quote Mishkin (1999):
The performance of inflation-targeting regimes has been quite good. Inflationtargeting countries seem to have significantly reduced both the rate of inflation and
inflation expectations beyond that which would likely have occurred in the absence of
inflation targets. [Italics added].
However, inflation rates were on a downward trend in all over the world well before the
advent of the IT regimes and this trend carried on in the 1990s, which was also acknowledged
by some IT proponents. To be more concrete, according to the World Bank statistics, average
global inflation rate was 12 percent in 1981, it decreased to 7 percent in 1989 and to just 3
percent in 1999. As of 2014, this number stood at 2.5 percent. This lends support to the idea
that in the 1990s and 2000s both IT and non-IT regimes lowered their inflation rates, as all of
them as “non-IT regimes” did in the 1980s! To quote Angeriz and Arestis (2008):
[W]e have produced evidence that suggests that non-IT central banks have also been
successful in achieving and maintaining consistently low inflation rates. It follows
then that this evidence would suggest that a central bank does not need to pursue an IT
strategy to achieve and maintain low inflation.
And Dueker and Fischer (2006) finishes their survey rather succinctly in this regard:
[I]nflation-targeting countries generally followed a non-inflation targeting neighbor in
reducing their baseline or trend inflation rates. … [O]n the heels of a decade of low
global inflation, it has been hard to argue that formal inflation targets have led to any
divergence between targeters and non-targeters in terms of inflation performance.
Second, mainstream economics assessed the performance of the IT regimes just in terms of
inflation rates and how these regimes managed to lower their inflation rates in the 1990s and
2000s. Real economic variables such as economic growth and employment level, not to
mention income distribution, attracted much less attention in the evaluation of the IT regimes
as Rochon and Rossi (2006) expressed a decade earlier:
[p]roponents of inflation targeting often trumpet the success of inflation-targeting
regimes. Success in these cases, however, is usually measured in terms of their impact
on inflation, with little or no consideration for real factors or other economic policy
goals, such as the reduction of unemployment and poverty as well as the maximization
of output. [p. 616].
In this paper, we address these problems and investigate the performance of this monetary
policy regime both theoretically and empirically. In the next section, we explore theoretical
foundations of IT regimes. In the third section, we consider the detrimental effects of
overemphasis of IT on the real economy. Finally, in the fourth section we conclude with
economic policy suggestions.
Theoretical Foundations of Inflation Targeting Regime
In the new globalized and financialized world, central banking has become much more
powerful and important in comparison to Bretton Woods era wherein central banks had had a
rather passive role in the domestic economy. In parallel with this process, the way central
banks operate monetary policy in numerous countries changed dramatically in the 1990s and
2000s, and resulted in the so-called IT regimes. In this regime, monetary policy was largely
boiled down to but one overarching goal, that is achieving price stability through but one
measure, that is consumer price index. IT has been hailed as “good monetary policy” since
then. Although 2008-9 global financial crisis raised doubts regarding the viability of this kind
of monetary policy and numerous central banks including Fed implemented so-called
unconventional monetary policies after the crisis, the backbone and the mantra of the
monetary policy did not change and IT regime has stayed intact.
IT regime is very easy both to understand and to implement. However, theoretical background
of it is rather weak, although there has been a considerable consensus on IT since the
inception of it. There is no inflation or interest theory and Economics still lacks a full-fledged
monetary theory. At the heart of the IT regime lies the so-called Taylor rule, which is, in turn,
the embodiment and crystallization of the fundamental tenets of the new consensus in
economics, which shaped and informed central banking in all over the world in the 1990s and
2000s. Taylor rule rests on two fundamental concepts, namely natural rate of interest and
potential output. The former concept actually first put forth more than one century ago by
Wicksell (1898). However, the answer to the question of what is the level of the natural
interest rate is much more discretionary rather than theoretical. Indeed, in his seminal paper,
Taylor (1993) determined this rate with discretion as 2 percent, which is very close to
historical levels for US as Carlstrom and Fuerst (2003) revealingly states that
[b]ecause of the difficulty of measuring it [natural rate of interest], however, Taylor
assumed that the natural real rate is constant at 2 percent. He picked this number
because it is approximately the average real interest rate over a long-time horizon.
Moreover, there is no compelling reason to believe that such a concept actually exists in the
real world, and there are rather few attempts to prove theoretically the existence of it.
The latter one, on the other hand, is rather an elusive concept in economics and it emerged as
a reconceptualization of full employment output level. The questions of what is the potential
output level and does it change over time are yet to be answered satisfactorily in a theoretical
sense, if such a concept exists in the real world at all. To sum, IT regime has much more to do
with ideology and discretion rather than good monetary policy and rules.
Although there is no solid inflation theory in economics, however, mainstream economics
places great emphasis on combating inflation. This is rather evident in most of the
macroeconomics textbooks such that inflation is regarded as one of the most fundamental
concepts while income distribution concept is relegated to the sidelines. For example,
inflation is portrayed as one of the three major concerns of macroeconomics, alongside output
growth and unemployment, while income distribution cannot make into that list in the tenth
edition of the Principle of Macroeconomics of Case, Fair, and Oster (2012), which is one of
the popular undergraduate macroeconomics textbooks.
In mainstream economics, one of the arguments against inflation is that it disrupts decisionmaking process of individuals by making general price level less predictable and more
volatile. This way, individuals will be more prone to mistakes when they are trying to make a
decision, and less willing to have a decision in the first place due to uncertainty regarding
future of the economy emanating from unpredictable price levels. Thereby, resources in this
economy will be misallocated and the investments needed will not be realized. Another
argument against inflation is that it diverts resources from real economy to the financial one
and this results in more of speculative and less of productive investment, hence hurts
economic growth. In addition, inflation makes it harder for individuals to make everyday
monetary decisions and increases the burden and cost of the monetary transactions. In a
nutshell, the main rhetoric against inflation is that it disturbs the very fabric of the economic
process.
However, mainstream economics fails to recognize that not all inflations are bad. Actually,
this was evident in political and economic discourse in recent years that policy-makers in
several countries have desperately been trying to increase inflation in order to both escape
from deflation threat and revive the economy. Moreover, empirical studies on inflation
threshold started in the 1990s and proliferated in the 2000s and these researchers mostly
acknowledged that there seems to be a threshold below which inflation rate does not have a
negative effect on the real economy, albeit there is no empirical consensus on where that
threshold lies (for example, see Eggoh & Khan, 2014; Omay & Kan, 2010; Pollin & Zhu,
2006).
On the other hand, there is no theoretical threshold over which inflation rate starts to hurt the
economy. While some suggests that zero inflation rate is the best and this level perfectly
provides price stability, the impracticality of achieving this target and the threat of the
deflation in this level tipped the consensus in this regard to the 2 percent inflation rate for the
industrialized economies, and 4 percent for the developing economies in the mainstream
economics. In addition, the answer to the question of why do industrialized and developing
countries differentiate against each other in this respect is no better than that is what happened
in the real world in terms of inflation rates. To quote Carlstrom and Fuerst (2003):
[w]hile Taylor claimed that a 2 percent inflation target is preferred to 5 percent, there
is no agreement on whether it should be 2, 0, or, for that matter, –1 percent. Taylor
simply assumed a long-run inflation target of 2 percent (the average inflation rate since
1985 has been 2.6 percent). It should be kept in mind, however, that there is nothing
magical about 2 percent inflation.
Therefore, threshold inflation rate was determined rather arbitrarily and even there is no one
threshold but two: One for the countries which historically had higher inflation rates (this
generally applies to developing countries) and one for the countries which historically had
lower inflation rates (and this generally holds for industrialized countries).
While the inflation threshold over which the inflation rate starts to hurt the economy is
determined arbitrarily, there is near to no talk and discussion about the sacrifice ratio or
hysteresis effect as if there is no cost in decreasing inflation rate to the intended level and no
need to evaluating pros and cons of the monetary policy implemented in the new consensus,
not to mention theoretical inconsistency regarding neutrality of money. This manifests itself
in the well-known central banking motto that central bank tries to promote economic growth
and employment level unless these goals do not contradict with price stability goal, which
means before achieving the intended inflation rate, central bank do not take into account real
economy at all, and no matter what happens to the real economy, central bank first tries to
achieve price stability. To quote Atesoglu and Smithin (2006):
[I]t has even been argued that things such as a low rate of inflation are actually a
prerequisite for achieving other goals such as economic development, even though
this is hardly consistent with the underlying economic theory in which money is
neutral. [Italics are original].
And Frenkel (2006) indicates that
[t]he anti-inflationary target moved the employment objective to a secondary position,
while monetary policy became established as the macroeconomic policy par
excellence. … In the current version of inflation targeting, stabilization
macroeconomic policy limits itself to one sole anti-inflationary goal and is exclusively
performed by the monetary policy. [Italics added].
On the other hand, implied inflation theory of IT regime is rather reminiscent of Knut
Wicksell’s inflation theory, which was formulated as an extension of the quantity theory of
money a century earlier and started to attract much attention with the advent of the IT
regimes. Wicksell (1898) defines two kinds of interest in his formulation –natural rate of
interest and market rate of interest. To quote Wicksell (1898):
There is a certain rate of interest on loans which is neutral in respect to commodity
prices, and tends neither to raise nor to lower them. This is necessarily the same as the
rate of interest which would be determined by supply and demand if no use were made
of money and all lending were effected in the form of real capital goods. It comes to
much the same thing to describe it as the current value of the natural rate of interest
on capital. [p. 102. Italics are original].
In other words, natural rate of interest is defined as the rate at which supply of and demand for
money (capital) and capital goods are equal. At this point, Wicksell (1898) succinctly states
that
the transfer of capital and the remuneration of factors of production do not take place
in kind, but are effected in an entirely indirect manner as a result of the intervention of
money. … An increase in the demand for real capital goods is no longer a borrowers'
demand which tends to raise the rate of interest, but a buyers' demand which tends to
raise the prices of commodities. [p. 135].
That is, in Wicksell’s formulation, money is perfectly neutral and regarded as just a veil as in
the classical quantity theory of money and interest rate is the means that equals demand for
and supply of capital goods in the economy in the final analysis. On the other hand, Wicksell
assumed that while natural rate of interest is a built-in factor embedded in the economy,
market rate of interest is an exogenous variable, which can be and is set arbitrarily. Moreover,
supply of money is regarded entirely endogenous in Wicksell’s formulation. That is, while
natural rate and money supply is determined by the market forces, market rate is set by
commercial banks and if there is a mismatch between market rate and natural rate of interest,
then things go awry in the economy. For example, if market rate rises above natural rate of
interest, then supply of savings exceeds demand for capital and as a result of that both credit
volume and money supply in the economy dwindle, and because of the falling demand in the
face of higher market rate of interest, commodity prices fall. Hence lower inflation. On the
other hand, if market rate of interest decreases below of natural rate, then things happen the
other way around: Demand for capital exceeds supply of savings and consequently both credit
volume and money supply expand, and due to the rising demand emanating from lower
market rate of interest, commodity prices rise. Hence higher inflation.
In the bottom line, in Wicksell’s inflation theory, mismatch between natural rate and market
rate of interest paves the way for lower or higher demand in the economy and this results in
the higher or lower inflation in the economy. The implied monetary policy conclusion from
this theory is that if a central bank wants to decrease inflation, then it should increase policy
interest rate. And, indeed, this is the very policy advice of the new consensus
macroeconomics, and Wicksell’s inflation theory (which can be regarded as an interest theory
as well) is very much in spirit with Taylor’s rule, which is the backbone of the IT regime.
Former Bank of Canada economist Clinton (2006) states very clearly how this is the case for
numerous central bank around the world in an article revealingly named “Wicksell at the
Bank of Canada”:
[T]he Bank of Canada adopted a neo-Wicksellian approach to monetary policy. Since
the bank led the way for many other central banks, and since the approach has had
wide success, the story has broad, international relevance.
Moreover, then Federal Reserve Governor (and now President) Janet Yellen (1995) stated at
the FOMC meeting in 1995 that how Fed was using the Taylor rule for about a decade then
and how she preferred this policy:
[I]t seems to me that a reaction function in which the real funds rate changes by
roughly equal amounts in response to deviations of inflation from a target of 2 percent
and to deviations of actual from potential output describes tolerably well what this
Committee has done since 1986. This policy, which fits the behavior of this
Committee, is an example of the type of hybrid rule that would be preferable in my
view, if we wanted a rule. I think the Greenspan Fed has done very well by following
such a rule, and I think that is what sensible central banks do. [p. 43-44, italics added].
One of the major tenets of the IT regimes is that inflation is almost entirely regarded as a
demand-driven monetary phenomenon. In this regard, cost inflation is overlooked as
transitory and unimportant. In addition, although there are several monetary channels such as
interest rate channel or exchange rate channel through which inflation could arise, highly
complex monetary transmission mechanism was reduced to a black box in which we do not
know meaningfully what happens inside, but proponents of IT regime pretend that they do
know what gets in and what gets out: If higher interest rate gets in the box, then definitely
lower inflation rate and higher economic performance get out. On the other hand, while
monetary policy is reduced to fighting demand inflation in a narrow sense, fiscal policy is
altogether discarded on the grounds that it is not conducive to “good monetary policy” and
hence inflationary in the new consensus macroeconomics. However, if monetary policy is
affecting the real economy through various transmission channels and overlooking fiscal
policy does not lead to good macroeconomic policy, then it means that IT regime makes more
harm than good, to the contrary to what IT regime proponents claim.
Inflation Targeting and Real Economy
New consensus macroeconomics has given utmost importance to monetary policy and
dismissed fiscal policy as both ineffective and inflationary. Therefore, the consensus in
macroeconomics today is much more of a monetary theory, which is actually a modern
extension of classical quantity theory of money, than of anything else. While quantity theory
of money assumes the exogeneity of money, new consensus economists today seem to accept
endogeneity of money in the IT regime framework, mainly due to mounting theoretical and
practical evidence against exogeneity and in favor of endogeneity.
With the collapse of the Bretton Woods regime and the fall from grace of the Keynesian
economic policy analysis in the 1970s, Monetarist approach to the monetary policy after M.
Friedman had gained much credibility and as a result of that several central banks had toyed
with Friedmanian approach to monetary policy with a monetary aggregates target. However,
targeting money aggregates was proved to be unfruitful and having little relevance to the
actual workings of the economy due to not exogeneity of money and erratic behavior of the
velocity of money, this approach was quickly abandoned. After this brief period, IT started to
emerge as the consensus approach to monetary policy, having significant resemblance to
neoclassical approach to monetary policy except the endogeneity of money.
Endogenous money theory has its roots in the workings of such as Keynes, Schumpeter and
Robinson, and has been revitalized by, inter alia, Davidson (1972), Kaldor (1970), Moore
(1979) and Minsky (1982) in the 1970s and 1980s. With the refinements in the 1990s and
2000s, as Fontana (2002) puts it, endogenous money theory is “now one of the main
cornerstones of Post Keynesian economics.” Endogenous money theorists believe that
resulting monetary aggregates are the end product of the economic process in the economy.
That is, monetary aggregates are not imposed to the economy at the beginning, far from it,
they are determined minutely in the economy as banks lend, firms and individuals borrow
money, and central banks set interest rate (Fontana & Palacio-Vera, 2002).
Therefore, while monetary aggregates targeting policy fell out of favor in the 1980s, interest
rate policy rule increasingly adopted both in academia and by policy-makers such as
Volcker’s Fed, resulting in the so-called IT regimes. In the IT regime, besides the
endogeneity of money, excessive demand has been recognized as the sole reason of the
inflation and neutrality of money in the long-run significantly emphasized, together with the
acceptance of the existences of the so-called “natural” real interest rate, non-accelerating
inflation rate of unemployment, or NAIRU, and “potential” economic growth.
In this rhetoric, since money is neutral in the long-run and inflation arises as a result of the
excessive demand in the economy, in line with the implicit acceptance that no matter the
inflation level per se, “the lower the inflation rate, the better”, central banks have been
encouraged and in a sense urged to pursue disinflationary policy whenever consumer basketbased inflation or inflation expectations for the future is above the targeted level, even the
discrepancy is in the order of 0.5 or 1 percentage point, without the need to even worrying
about real economic variables such as economic growth and employment. That is, neutrality
of money in the long-run guarantees that there would be no adverse effect of disinflationary
process or of persistently higher than necessary-interest rate on the real economy.
However, if money is not neutral in the long run and inflation is not solely or even primarily
determined by excessive demand, and economic gains of decreasing inflation, let say, from 3
to 2 percent via increases in (nominal) interest rate is negligible or even none, then the whole
IT paradigm proves to be seriously flawed and monetary policy of the new consensus is
significantly misguided.
Indeed, in the Post Keynesian paradigm, there is no dichotomy such that monetary variables
and real economic variables live in their own realms and have nothing to do with each other in
the long run. For the Post Keynesians, money is not neutral in the long run, as well as in the
short run. That is, monetary variables can and do have significant effects on the real economic
variables via different channels such as hysteresis effect or market imperfections. On the other
hand, Post Keynesians think that inflation is primarily driven by cost-push factors, not
excessive demand. This is all the more relevant in the last decades in which both
overproduction and underconsumption prevail in the whole world.
IT regime proponents usually defend this paradigm that it yielded lower inflation rates to the
countries who embraced it. However, there is no compelling reason to believe that actually
this is the case and there is no empirical proof that IT regimes did better than non-IT regimes
in terms of inflation rates. Moreover, monetary policy or inflation rate is not an end itself.
That is, the viability of any economic policy should be assessed by its effects on real
economic variables.
The empirical literature regarding the relationship between economic growth and inflation
produced mixed results. While some studies found that there is a negative relationship (see
Bittencourt, 2012; Grier & Grier, 2006; Gylfason & Herbertsson, 2001; Wilson, 2006), others
found a neutral and even a positive relationship (see Black, Dowd, & Keith, 2001; Bruno &
Easterly, 1998; Mallik & Chowdhury, 2001). However, the negative relationship between
these variables could only be observed in countries with very high inflation rates as Bruno and
Easterly (1998) put it rather succinctly:
Recent articles in the new growth literature find that growth and inflation are
negatively related, a finding that is usually thought to reflect a long-run relationship.
But the inflation-growth correlation is only present with high frequency data and with
extreme inflation observations; there is no cross-sectional correlation between longrun averages of growth and inflation. [Italics added].
And Ericsson, Irons, and Tryon (2001) notably conclude that:
The negative correlation between inflation and output growth obtained by crosscountry regression is not robust to changes in model specification. The selection of
countries in the sample, the level of aggregation over time, and the choice of dynamic
specification all affect the results obtained. … If Africa and Latin America are
dropped from the sample, the coefficient on inflation in the growth regression becomes
positive and statistically insignificant. For the OECD countries by themselves, no
economically important, statistically detectable, long-run relationship appears to exist
between output growth and inflation. [Italics added].
On the other hand, in the 2000s another strand of this literature increasingly gained
popularity. While previous studies assumed that there is a linear relationship between inflation
and economic growth, this threshold studies suggested that inflation-growth relationship is
actually nonlinear and there is a threshold over which inflation rates start hurting the
economy and under which there is no negative effect of inflation on growth and even there is
a positive one (see Eggoh & Khan, 2014; López-Villavicencio & Mignon, 2011; Omay &
Kan, 2010; Pollin & Zhu, 2006; Vinayagathasan, 2013).
For example, Pollin and Zhu (2006) investigate this relationship by producing nonlinear
regression estimates for 80 middle income and low income countries over the period of 19612000 and consistently find “that higher inflation is associated with moderate gains in gross
domestic product growth up to a roughly 15–18 percent inflation threshold.” [Italics added].
In addition, Eggoh and Khan (2014) analyze 102 industrialized and developing countries over
the period of 1960-2009. They report that the inflation threshold is 3.4 percent for the
developed countries, 11 percent for middle-income countries and 20 percent for low-income
countries. Overall, although these studies differ on the level of the threshold, a certain pattern
emerges, which is roughly that threshold inflation level is 3-5 percent for the industrialized
economies and 15-30 percent for the developing countries.
In a nutshell, this literature reveals that while rather high inflation rates do hamper economic
growth, mild or even moderate inflation rates do not have a negative impact on economic
growth, and these inflation rates even can boost economic growth. To quote from Eggoh and
Khan (2014):
The recent literature has confirmed that the relationship between inflation and growth
is nonlinear and that there therefore exists a certain threshold above which inflation is
harmful and below which it enhances growth. [Italics added].
And Pollin and Zhu (2006) indicate that:
Certainly, for the middle- and low-income countries, our results strongly suggest that
allowing inflation to be maintained in the range of 10 percent or somewhat higher is
likely to be consistent with higher rates of economic growth. [Italics added].
Therefore, if mild inflation is not harmful to the real economy and even conducive to
economic growth, then, IT policies carried out by central banks are actually doing much more
harm than good. First, setting (nominal) interest rate consistently higher than what it should
be will have real economic consequences such as weaker economic growth, lower investment
and more unequal income distribution. (Note that this holds whether money is neutral in the
long run or not and is yet another indicator of the possible futility of the debate regarding the
neutrality of money -there is no neutrality or dichotomy whatsoever in the economy). We
already mentioned that there may even be a positive relationship between economic growth
and inflation, let alone a negative one, particularly under a certain threshold inflation rate. In
addition, Atesoglu (2005) has shown that trying to lower inflation rate actually resulted in
lower real investment over the period of 1947-2001 in the US, and concluded that in the long
run a positive relationship between investment and inflation could exist particularly via a
certain kind of monetary policy, which consistently sets (nominal) interest rate higher than
necessary.
On the other hand, higher than necessary interest rates in the long run should have distributive
consequences in the economy, to the detriment of “common man” and general public and in
favor of rentiers, though the effects of higher interest rates on income distribution have been
largely ignored by mainstream economics. In addition, these distributional changes in the
economy could result in lower effective demand and higher unemployment in the economy.
Indeed for Keynes, functional income distribution is of significant importance in the way of
achieving full employment level and for the healthiness of the general economy as Argitis
(2008) indicates:
Keynes attributed the failure of capitalism to sustain the full employment of resources
to income distribution, while the latter was viewed as a factor that has a straight
influence on effective demand. … For Keynes, what seems to principally matter for
the economic efficiency and the social and political stability of capitalism is the
income distribution between rentiers and the “active earning classes” of workers and
entrepreneurs. [Italics added].
Rochon and Rossi (2006) analyzed the countries who adopted IT regime with regards to the
changing situation of the wage earners in the general economy and revealingly concluded that
the share of the wage earners has actually declined after the introduction of the IT in general.
For example, New Zealand is the first country ever to implement IT regime and has been
extolled as a success story by mainstream economics. However, the share of wage earners in
this very country declined significantly with the advent of IT regime in 1990, from 50 percent
(1980-1989) to just 43 percent (1990-2003). Sweden experienced a similar deterioration, the
share of wage earners declined from 58.4 percent (1980-1992) to 53 percent (1993-2004).
Second, if central bank pursues a disinflationary monetary policy in an effort to decrease an
already mild inflation rate, then it hurts the economy without gaining next to nothing in
return. While setting (nominal) interest rate consistently higher than necessary will have a
permanently negative effect on the economy, the recessions caused by disinflationary “tight”
monetary policy periods may scar the economy irreversibly through the hysteresis effect and
market imperfections, and propel the economy to a permanently lower potential output level.
Cerra and Saxena (2005) report that economic recession due to banking crisis resulted in a
lower potential output and higher unemployment in Sweden. In addition, in a comprehensive
empirical study, Cerra and Saxena (2007) analyze 192 countries over the period of 1960-2001
and provide evidence that output losses in economic recessions are permanent on average and
these recessions lower potential output level. Mota and Vasconcelos (2012) provide evidence
that equilibrium state of employment is path dependent and “determined by the history of
previous adjustments.” That is, recessions wound employment level in the long run as well as
in the short run as Jayadev and Konczal (2011) notably indicates that
[f]or as aggregate demand remains weak, there will be a continued increase in those
who drop out of the labor force. The scars of unemployment show up decades later for
these unemployed and absent from the labor force workers. Worse, these workers
could, through a hysteresis effect, drag the long-run behavior of unemployment even
higher. [Italics added].
Conclusion
With the emergence of the new consensus macroeconomics and neoliberalism, IT came into
prominence in the 1990s. Starting with New Zealand, one central bank after another adopted
and cherished this regime. Proponents of this regime mainly argued that IT regime was
successful on the grounds that it resulted in lower inflation rates and hence better economic
performances. However, inflation rates in the world were in a downward trend from 1980s
well into 2000s, and both IT and non-IT regimes managed to decrease their inflation rates. In
addition, focusing too much on price stability through IT paved the way for permanently
higher than necessary interest rates and disinflationary “tight” monetary policy periods when
inflation rate was above an arbitrarily targeted level.
On the other hand, mainstream economists generally assumed that IT was beneficial to the
real economy through only price stability and it was enough to look at inflation rates when
assessing the success level of the IT regimes and thereby overlooked the effects of monetary
policy implemented on the real economy. However, tight monetary policy can and do affect
the real economy negatively and overemphasizing price stability may hurt the economy in
terms of lower potential output, decreasing investment and more unequal income distribution.
Moreover, there is now considerable evidence in the literature that the relationship between
inflation and economic growth is not linear and there is a threshold under which inflation is
not a hindrance, but even conducive to economic growth.
After the 2008 global financial crisis, central banks around the world have been toying with
so-called unconventional monetary policies under the IT regime umbrella. Recently Nouriel
Roubini (2016) wittily argued that since these unconventional policies have been used by
central banks widely and thus became conventional per se, and yet failed to bring about
expected economic outcomes, the world now needs an unconventional conventional monetary
policy. Actually, what is needed is not toying with unconventional policies, but is the
complete transformation of the monetary policy framework. “Good” monetary policy should
stand up to empirical evidence and there is now significant evidence that money is not neutral
and monetary policy can affect the real economy permanently. Central banks should come to
realize that they are focusing too much on monetary variables by having one overarching monetary- goal and hence ignoring the real economy, which should be the ultimate concern
for any kind of economic policy. Monetary policy is not a panacea for the economic troubles,
but it can be yet another trouble for the real economy itself.
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