Palley Targets Inflation Targeting

Other than the occasional call for Canada to adopt the US dollar, discussion of Canadian monetary policy mainly consists of the C. D. Howe Institute and the Bank of Canada praising inflation targeting. As Thomas Palley reminds us, another perspective exists:

The Case Against Inflation Targeting

A few months ago the Federal Reserve seemed to be inexorably moving toward adopting an inflation targeting policy regime. Fed Chairman Ben Bernanke is known to support such a framework having co-authored several articles and books on the subject. Moreover, his institutional hand had been strengthened by Frederic Mishkin’s appointment as Vice-Chairman of the Fed, Mishkin being one of Bernanke’s co-authors.

This situation has been transformed by Congressman Barney Frank’s assumption of the Chairmanship of the House Financial Services Committee. That is because Frank is known to be an inflation targeting skeptic, and his Chairmanship sets the stage for an important policy debate that also pertains to policy in Europe, Canada, and developing economies.

The economics profession is widely identified with supporting inflation targeting. However, the profession is also unusually monolithic, which makes it important that alternative positions get heard.

Former Federal Reserve Chairman Alan Greenspan long opposed inflation targeting on “process” grounds. Though known as an opponent of inflation, Greenspan’s view was that an explicit inflation target would be a millstone around the Fed’s neck. In particular, it would limit flexibility and discretion to adjust policy in response to unexpected circumstance. Additionally, inflation targeting could promote damaging mechanical policymaking, as happened with money supply targeting in the late 1970s. Lastly, it could provide an anvil on which financial markets could hammer and corner policy.

Greenspan’s opposition reflects his policymaker acumen. But there is a deeper case against inflation targeting that rests on economic theory and differences in the way the economy is understood.

Today’s economic consensus is rooted in Milton Friedman’s notion of a natural rate of unemployment that harkens back to classical economics, which ruled thinking in the Great Depression era. According to this classical view inflation and monetary policy have no lasting impacts on the unemployment rate or real wages, which are determined by labor supply and demand conditions that are independent of inflation. Moreover, inflation cannot affect economic growth, which is determined by labor force growth and the rate of technological advance that are again independent of inflation.

These propositions represent today’s consensus. But there is another view that holds there is a trade-off between inflation and unemployment. Slightly higher inflation can reduce unemployment because it greases the wheels of adjustment in labor markets. It is hard to lower wages because of trust and conflict issues. Consequently, instead of lowering wages in depressed sectors it is more efficient to raise wages and prices in the rest of the economy, thereby accomplishing the relative price adjustments needed to restore full employment.

Lower unemployment can in turn raise real wages because it gives workers more job options and increases their bargaining power. Finally, higher wages may raise growth by strengthening consumer demand conditions and stimulating investment – but this requires the economy to be “wage-led”. Alternatively, if the economy is “profit-led”, higher wages may lower growth by diminishing profitability and discouraging investment.

The important point is there are two competing coherent views of the economy, and they generate very different policy perspectives. According to the current consensus, monetary policy only affects inflation, which encourages very low inflation as the Fed’s goal. However, the minority post Keynesian view sees monetary policy as having lasting impacts on inflation, unemployment, real wages, and maybe growth. That makes inflation one concern among many.

This difference means that inflation targeting is an undesirable frame for public policy. Inflation is a “bad” in the sense that we would all prefer high employment without inflation. Consequently, if monetary policy is presented purely in terms of an inflation target, there will be a tendency to choose a low target. If the choice is presented as two versus three percent inflation, two percent is likely to win out and policy will also tend to privilege addressing inflation risks over employment risks.

However, if the reality is monetary policy impacts a quadruple consisting of inflation, unemployment, real wages, and growth, two percent inflation may be inferior to three percent inflation accompanied by higher real wages, lower unemployment, and possibly faster growth. That is the economic logic behind skepticism about inflation targeting as a policy framework.

Copyright Thomas I. Palley


  • The big question is how inflation is measured and what does it really mean?

    Since neoclassical, globally competitive market economics raised its ugly head some 35 years ago, the general cost of living has inflated at least 1000%, but wages, at least some wages, perhaps doubled. Supermarket prices went up 3 to 500% since NAFTA alone.

    Then, what do we mean by inflation?

    Years ago I could buy an electric drill that would last 30 odd years. In the past year I threw out 3 new ones that died, because of the “cheap” prices we no longer have repair shops of any kind, filling our dumps with polluting waste. The same for TVs etc. and computers are made to last only 1-2 years on account of “technological advances”. Is this not inflation ? How about the fantastic, sculptured headlights on cars, costing hundreds, no bumpers, where the smallest body repairs, or cracked, warp around windshields, cost over $1000.?

    The same for clothing. A working shirt, made in Canada, that used to last many years, now comes from China or Bangladesh and wears out in months.

    Are these sordid facts, economists never talk about, not inflation, plus inflated cost transfers in the forms of waste and pollution?

    Of course, there have been economists, like Veblen, who have foreseen decades ago, what unbridled corporatism will bring, but their voices have been silenced by hucksters like von Hayek, Friedman and their disciples at the Chicago School and its outcrops, like the CD Howe and Fraser and a hundred more “charitable” institutions, set up to sell legalized destruction, as “wealth creation”.

    So, how do we measure the inflation caused by the free money creation powers of deregulated banks, that now mostly goes into overcapitalization, colonization, fascism and enslavement, like the proposed North American Competitiveness Council, planned by big business to rule the NAU.

    In any case, there have been many monetary systems designed and invented to eliminate so called “inflation”, e.g. the one by the American economist Ralph Borsos, some 100 years ago.

    Is the status quo worth the destruction of the ecology and humanity? Isn’t it about time to get rid of all ideology based economic systems and forget the distorted words of long dead prophets and start using our heads ?

    Ed Deak.

  • Here’s another example of the terrible damage caused by the irresponsible inflation of the money supply, for the purpose of overcapitalized and automated mass production.

    Yet, never mentioned, or calculated as inflation, neither are the costs transferred on humanity in the forms of illnesses, family breakdowns, substance abuse, crimes.

    According to the Bank of Canada’s Mr.Dodge, we’ve had a 2% inflation in this country, for years?

    Does anybody believe him ?

    Ed Deak.
    Subject: China’s “booming economy”

    Pollution ‘hits China’s farmland’

    More than 10% of China’s farm land is polluted, posing a “severe threat” to the nation’s food production, state media reports.

    Arable land shrank by nearly 307,000 hectares (760,000 acres) in the first 10 months of 2006, government officials were quoted as saying.

    Excessive fertiliser use, polluted water, heavy metals and solid wastes are to blame, the reports said.

    Rapid economic growth has had a damaging impact on China’s environment.

    Its cities, countryside, waterways and coastlines are among the most polluted in the world.

    The Ministry of Land and Resources said agricultural land in China fell to 121.8 million hectares (30 million acres) by the end of October 2006 – a loss of 306,800 hectares since the start of the year.

    Heavy metals alone contaminate 12m tonnes of grain each year, causing annual losses of 20bn yuan ($2.6bn), China’s Xinhua news agency quoted the ministry as saying.

    Land and Resources Minister Sun Wensheng said agricultural land in China must not be allowed to fall below 120 million hectares.

    “This is not only related to social and economic development, but is also vital to the long-term interests of the country,” he was quoted as saying.

    China’s government has promised to spend heavily to clean up the country’s heavily polluted environment.

    But clean-up efforts are often thwarted by lax enforcement of laws and administrative activity at a local level, correspondents say.

    Story from BBC NEWS:

    Published: 2007/04/23 07:21:38 GMT


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