Silent inflation

Once thought of as the ultimate economic danger, inflation is now generally recognised to be an acceptable, sometimes even necessary, ingredient in the recipe for growth. However, this laissez-faire attitude could end up distorting contemporary perceptions of economic success

Author: Robert Shiller, Professor of Economics, Yale University
April 25, 2019

In many countries, inflation has become so low and stable in recent decades that it appears to have faded into the woodwork. Whereas galloping inflation was once widely viewed as the number one economic problem, today most people – at least in the developed countries – hardly ever talk about it, or even pay attention to it. But ‘silent inflation’ still has subtle effects on our judgment, and it may still lead to some consequential mistakes.

If one is not careful to remember the effects of inflation on all prices, it might seem that we are living in a successful new era

Hitting the target
Since New Zealand’s central bank set the first example in 1989, monetary authorities around the world have increasingly pursued a policy of setting inflation targets (or target ranges) that are substantially above zero. That is, policymakers plan to have inflation, but steady inflation. What used to be a dirty word is now announced publicly, and moderation is enforced.

Central Bank News tabulates these targets for 68 countries. The European Central Bank targets annual inflation in 2018 at “below, but close to, two percent”. In Canada, Japan, South Korea, Sweden, and , the 2018 inflation target is two percent. China and Mexico target three percent annual price growth. In India and Russia, the target rate is four percent. It is five percent in Ukraine and Vietnam, and six percent in Azerbaijan and Pakistan. Some countries have had double-digit inflation targets: Egypt has set a target of 13 percent, plus or minus three percent, for this year. But most countries have set their 2018 inflation targets at between two and six percent.

It is worth translating these annual inflation targets to longer-term inflation, assuming that the target is not changed in the coming years. Inflation of two percent per year implies 22 percent inflation over a decade, or 81 percent inflation over 30 years. That will make numbers measured in currency look a lot bigger over time, even if nothing real is changing. It is a lot worse if one considers a six percent inflation rate: at that pace, prices would rise 79 percent in 10 years and almost six-fold in 30 years.

Such policies cause a sort of magnification of the present in the minds of most people. Suppose you ask someone who has been living in the same house for 30 years what he or she paid for it – the purchase price will probably look ridiculously small. If one is not careful to remember the effects of inflation on all prices, it might seem that we are living in a magnificently successful new era. With silent inflation, it can be easy to forget that the truth is much less dramatic.

At the same time, in an age of internet rumours and fake news, the world today can look a little unmoored from history. That might create a sense of real risk.

Residual effects
Inflation targeting has other effects too, which seem to be more on the minds of central bankers.In his influential 1998 book Inflation Targeting, Ben Bernanke and his co-authors advised policymakers to announce a target inflation rate because it “communicates the central bank’s intentions”, which would “reduce uncertainty”. The announced rate should be substantially positive, they wrote, because if officials tried to get it close to zero, any mistake could result in deflation, which “might endanger the financial system and precipitate an economic contraction”. As Federal Reserve Chair from 2006 to 2014, Bernanke formally introduced inflation targeting in the US in 2012, setting the annual rate at two percent, where it has remained ever since.

But reducing uncertainty about prices by keeping the inflation target at two percent or more might actually increase a sense of uncertainty about real things, like home values or investments. While it is right to worry about massive deflation, the historical relationship between deflation and recession is not all that strong. In a 2004 paper, the economists Andrew Atkeson and Patrick Kehoe concluded that most of the evidence of a relationship comes from just one case: the Great Depression of the 1930s.

Beware the spin
The news media’s tendency to fixate on new records serves their short-term interest in creating the impression that something really important has happened that justifies readers’ or viewers’ attention. But sometimes there is a bit of fakery in the record, especially when the record is described in nominal terms and we have steady inflation. As a result, the emphasis on records can encourage a disrespect for history and nurture a sort of disorientated feeling that we live in exceptionally uncertain times.

For example, sometimes the stock market has set a new record, whether up or down, which is nothing more than the result of inflation. On February 5, 2018, the Dow Jones Industrial Average 4.6 percent, far below the record 22.6 percent on October 19, 1987. But media reports chose to point out that the February 5 drop was the biggest ever one-day decline in absolute terms (1,175 points on the Dow Jones Industrial Average). Presenting a drop this way is misleading, and might encourage some panic selling. The amplitude of stock market point swings invariably grows with general inflation in all prices.

The money illusion even bleeds into impressions of the ‘strength’ of the economy, as if a high level of GDP growth or a bull market are indicators of the health of something called the economy. GDP growth numbers are conventionally reported in real (inflation-adjusted) terms, and unemployment numbers are unit-free. But reporting of just about every other major economic indicator is generally not corrected for inflation.

An inflation target of a few percentage points may seem to promote stability, and perhaps it really does. But we need to consider the possibility that it may lead to subtle misperceptions that have the opposite effect on the stability of our judgments.

© Project Syndicate 2019