Singapore - Letting inflation in by the back door

A key tenet of central banking is that while a democratic government can and will play Robin Hood - taxation is all about robbing Peter to pay Paul - the country's monetary authority must not act like Little John, the chief lieutenant to the prince of thieves.

That is because inflation, which is what a central bank tries to control, is the mother of all taxation. It stealthily transfers wealth from savers to borrowers.

When a society entrusts a bunch of unelected officials at the central bank with the responsibility for managing prices, it does so with a clear mandate that they shall resist any such resource transfer, including to the government of the day.

This orthodoxy is now facing a serious challenge. There is now growing support for the idea that the United States Federal Reserve must somehow - anyhow - produce a little bit of extra inflation.

Mr Kenneth Rogoff, a former chief economist at the International Monetary Fund, has proposed 4 per cent to 6 per cent inflation for a few years.

It will make "real", or inflation-adjusted, interest rates negative, so both business spending as well as debt-fuelled purchase of big-ticket consumer items such as cars will get a boost. More workers will be hired, solving a sticky unemployment problem. And the US economy, which is teetering once again at the edge of a recession, will be back on a stable growth path.

Or so goes the argument.

Unexpected inflation will also push up the dollar value of economic output. That will lead to higher tax revenues for the government, making it easier for it to service existing public debt. According to some estimates, inflation of 6 per cent over four years could reduce the US public debt-to-gross domestic product (GDP) ratio by 20 per cent.

A lower debt burden will mean less pressure on the government from the political right to prune public spending. This, too, could have a salutary effect on consumer and business confidence.

How exactly will the Fed manufacture inflation? The mechanism is fairly straightforward: The central bank will commit itself to buying any amount of US government debt, paying for these purchases with newly created money. As larger quantities of money become available to buy the goods and services being produced, their prices will have to rise.

Not all this money will circulate within the US economy. A significant chunk of it will chase assets such as real estate and stocks in faster-growing Asian economies, posing a risk to financial stability. Any commitment by the US Fed to higher inflation will thus give a splitting headache to central bankers in our region.

More than foreigners' ire, the domestic unacceptability of such a course of action is what is preventing it from becoming policy. After all, the Fed is legally duty-bound to keep prices stable.

A solution that gets around this difficulty has been found and is being enthusiastically championed by Mr Jan Hatzius, who is the chief US economist at Goldman Sachs, as well as Ms Christina Romer, a former chief economic adviser to US President Barack Obama and a co-author of his 2009 fiscal stimulus plan.

The idea, which you can expect to hear more about as it increasingly becomes mainstream, is that the Fed should adopt an explicit nominal GDP target. (At present, the US central bank does not aim to hit a specific numerical goal.)

Nominal GDP is the current-dollar value of everything produced by an economy in a year. It is currently about one-tenth lower than what it would have been if the level of output reached in 2007 - when the US economy was at full employment - had continued to grow 4.5 per cent annually, according to Mr Hatzius. (If real GDP rises 2.5 per cent, and prices rise 2 per cent, nominal GDP grows by about 2+2.5 = 4.5 per cent.)

If the Fed accepts Ms Romer's proposal and chooses to target 4.5 per cent growth in nominal GDP every year, it will essentially be telling the world that as long as the economy remains weak, the central bank will not only tolerate higher inflation, but it will also actively seek it.

For instance, if instead of expanding 2.5 per cent, the real economy grows only by 1 per cent, then the Fed will be well within its power to make up the shortfall in nominal GDP by seeking inflation of 3.5 per cent, instead of 2 per cent. (1+3.5 = 4.5 per cent.)

A publicly announced nominal GDP target means that people will know beforehand that the Fed wants to usher in price gains through the back door. The inflation that the Fed is seeking to engineer will get embedded in expectations.

There is no guarantee that the increase in expected inflation will remain "small", as Ms Romer expects, especially when such expectations start to get entrenched in wages. If inflation does gallop to, say, 4.5 per cent, the Fed's target will force it to raise the cost of money so high that real GDP growth comes in at zero. In other words, the Fed will have to let the economy stagnate. Interest rates could thus become more volatile from one year to the next.

An open-ended commitment by the Fed to keep buying bonds until nominal GDP growth hits its preferred target is also a recipe for a weak dollar. While a competitively priced currency may spur US exports, it will also set the stage for trade spats, especially with China.

Targeting nominal GDP is a seductive idea because it has the appearance of being a rule-based monetary policy, which is what conservative economists and politicians want the Fed to pursue. But the apparent soundness of the proposal may just be an illusion. Once the custodian of a currency's purchasing power is seen to covertly support its erosion, the central bank will be left with zero credibility.

For the Fed to lose all credibility for responsible monetary management in the eyes of Chinese and Saudi creditors to the US government may have unpleasant consequences in the bond market. By targeting nominal GDP, the Fed may end up stoking runaway inflation, or causing a deep recession. Or both.

Andy Mukherjee

The Straits Times

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