Brian Fallow: Big risks in letting inflation loose

It is almost as if the Vatican expressed second thoughts about contraception or clerical marriage.

The International Monetary Fund's chief economist, Olivier Blanchard, has written, and more to the point made public, a paper calling into question some of the articles of faith of the Washington consensus, in particular the importance attached to maintaining low and stable inflation.

Given the magnitude of the financial crisis it is neither surprising nor inappropriate the conventional wisdom on macro-economic policy prevailing in the period preceding it - "the Great Moderation" - should be up for scrutiny.

It was that the heavy lifting in dampening the cycle should be done by monetary policy, with one target (low inflation) and one instrument (a policy interest rate like the official cash rate).

Fiscal policy was thought to have at best a secondary role as a countercyclical tool and financial regulation was seen as a separate sort of task altogether.

But now it is clear, Blanchard says, that "we understand the relationship between activity and inflation quite poorly, especially at low rates of inflation."

As in the past decade inflation can be stable but accompanied by too much housing investment, too much consumption or too large a current account deficit.

Blanchard argues that when the crisis hit, central banks had limited scope to cut interest rates just when such cuts were needed most. Unconventional measures - quantitative easing - seem to have been sufficient to avoid the quicksand of deflation.

"[But] higher average inflation, and thus higher minimal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions."

He questions whether the net costs of inflation are much higher at, say, 4 per cent than at 2 per cent.

Many of the distortions from inflation arise from features of the tax system, the potential for bracket creep and the fact that it is nominal, not real, interest costs that are deductible. These, Blanchard suggests, might be corrected.

"Is it more difficult to anchor [inflation] expectations at 4 per cent than 2 per cent?"

This is not a rhetorical question, however, and the costs of getting the answer wrong are liable to be high.

It may be that people have a binary view: Either we have an honest dollar or we do not. Either we have a low inflation environment or we do not. Either we don't need to worry about how much less a dollar will buy next year or we do.

The transition in the late 1980s and early 1990s from an era of high and variable inflation to one of general price stability was a painful one.

A slippery slope which has the need to repeat that experience at the bottom of it is to be avoided, surely.

It is not immediately obvious that a softer inflation target would necessarily have meant there was more scope to cut interest when the crisis hit. It might just have meant lower real interest rates and nominal rates not much different from what they were.

New Zealand, which has a conventional inflation target with a mid-point of 2 per cent, had a policy rate over 8 per cent when the crisis hit. The Reserve Bank was able to cut by nearly 6 percentage points and still stay well clear of the dreaded "zero bound".

Nevertheless the idea that a "healthy dose of inflation" would be timely and useful has some serious proponents.

Some economists argue there are times when real wages need to fall and it is easier, or at least quicker, to do that through higher prices than a cut in nominal wages.

Inflation encourages spending over saving, which can be helpful at a time of weak demand.

It is also tempting when Government debt is soaring to debase the currency in which it has to be repaid.

But holders of the debt are liable to react with curled lips, narrowed eyes and an insistence on higher interest rates for further debt issuance.

It does not reduce the burden of the debt, it merely redistributes it from taxpayers to consumers.

Inflation is particularly hard on those with savings and those who are not in a position to pass on higher costs to their customers or their employers.

It is the economically weakest who have no one to pass the (devalued) buck to. That is why inflation has been called the cruellest tax of all.

Local advocates of a change in the monetary policy framework usually link it to a high and volatile exchange rate and the damage that does to exporters and firms competing with imports.

Why should the internal value of the dollar be all-important and its external value be left to whip around so destructively, they ask.

Blanchard evidently agrees. It is sensible, he says, for smaller countries to intervene on foreign exchange markets to smooth volatility and even to influence the level of the exchange rate.

But he acknowledges there are limits to such intervention and those limits can easily be reached if a country has large and prolonged pressures in its balance of payments.

New Zealand does if anyone does. We run large chronic current account deficits largely reflecting the cost of servicing net international liabilities equivalent to more than 90 per cent of our gross domestic product.

We are, in short, up to our nostrils in debt to the rest of the world and have to continually borrow more to pay the bills. This is hardly a good position from which to accumulate the large foreign currency reserves needed to try to manage the exchange rate as some Asian countries can.

The Government has, however, been able to administer a hefty dose of fiscal stimulus, equivalent to nearly 6 per cent of GDP over the past two years.

The IMF paper recognises the difficulty of using fiscal policy as a timely response to recession, because of the lags involved in the Budget process. Labour was already out of office by the time its tax cuts kicked in and National had been in power almost a year before its did.

So Blanchard advocates a new kind of automatic stabiliser, temporary tax relief or transfers which would be triggered when some indicator like unemployment crosses some pre-ordained threshold.

This intriguing idea comes with an admonition of fiscal discipline attached: "Low public debt in good times creates room to act forcefully when needed."

The IMF leopard hasn't changed all its spots.