Wednesday, October 3, 2007

Lawrence White on the Right Type of Inflation Target

Lawrence White has a interesting article in the most recent CATO journal titled "What Type of Inflation Target?" One point from his article is that an inflation targeting rule that only targets output prices is not sufficient to prevent the boom-bust cycles in asset prices we have seen over the past few decades. An excerpt:

"The remedy for central-bank-generated-asset-bubble problems isn’t continued discretion, but rather a better “price rule”... In other words: the problem isn’t in having a target, it’s in having a target limited to the CPI. A better target would incorporate asset prices, directly or indirectly, rather than only consumer prices. Examples of direct incorporation include a gold standard, a rule targeting an Alchian-Klein-type index that incorporates asset prices, or a rule targeting an index of input prices (wages and/or raw material prices). An example of indirect incorporation would be a rule targeting a broad measure of per capita nominal expenditure (Py), as proposed by George Selgin (1990), rather than only the CPI price index (P)."

Similar arguments have been made by others observers. Here is the Economist magazine in a 2005 article titled "Steering by a Faulty Compass." Some excerpts:

"When inflation targets were first introduced (in New Zealand in 1989), the exact measure of inflation did not matter much. The main objective then was to reduce high rates of inflation by anchoring expectations. Today, however, consumer-price indices are arguably too narrow. Charles Goodhart, a former member of the Bank of England's Monetary Policy Committee, has long argued that central banks should instead track a broader price index which includes the prices of assets, such as houses and equities...

The idea that central banks should track asset prices is hardly new. In 1911 Irving Fisher, an American economist, argued in a book, “The Purchasing Power of Money”, that policymakers should stabilise a broad price index which included shares, bonds and property as well as goods and services. Central banks already take account of asset prices by estimating their effect on wealth and hence on demand and future inflation, but the idea behind a broad price index goes much further, acknowledging that asset-price inflation can be harmful in its own right.

The most obvious way is through a giddying rise and subsequent crash of markets for shares or property. Big swings in asset prices can also lead to a misallocation of resources and so slower economic growth, just as high rates of general price inflation distort economies by blurring relative price signals. For instance, soaring property prices can encourage households to borrow too much and save too little, and can pull excessive resources into property at the expense of other forms of investment.

More fundamentally, if inflation is defined as “changes in the value of money”, then the consumer-price index is flawed because it only measures the prices of current consumption of goods and services. A classic paper written in 1973 by two American economists, Armen Alchian and Benjamin Klein, argued that people care about changes in the prices not only of the goods and services they consume today, but also of what they use tomorrow. Because assets are claims on future goods and services, their prices are proxies for the prices of future consumption. If I buy a house—i.e., a claim on future housing services—and its price is higher than a year ago, then surely that should be included in inflation since it reduces the purchasing power of my money. Many consumer durables, such as cars, which also provide services over several years, are already included in the CPI.

If the prices of goods and services and those of assets move in step, then excluding the latter does not matter. But if the two types of inflation diverge, as now, a narrow price index could send central bankers astray. Granted, asset prices are hard to measure: a rise in house prices may partly reflect an increase in the average quality of homes; and economists disagree over what weight house prices should have in a broad index. Yet buying a home is an enormous expense, so it is absurd to use such a rough approximation as rent, as does America's CPI, or to exclude the costs of owner-occupier housing altogether, as does the European Union's harmonised index of consumer prices."
Too bad the Fed did not incorporate these ideas into policy making over the past decade.

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