World Economy

Central Banks Overlook Value of Money

Central Banks Overlook Value of MoneyCentral Banks Overlook Value of Money

Over the past two decades, inflation targeting has become the predominant monetary policy framework. It has been essentially (though not explicitly) adopted by major central banks, including the US Federal Reserve, the European Central Bank and the Swiss National Bank.

But the 2008 global economic crisis, from which the world has yet to recover fully, has cast serious doubt on this approach, Axel Weber, chairman of UBS Group, wrote for Project Syndicate.

The Bank for International Settlements has long argued that pure inflation targeting is not compatible with financial stability. It does not take into account the financial cycle and thus produces excessively expansionary and asymmetric monetary policy.

Moreover, a major argument in favor of inflation targeting — that it has contributed to a decline in inflation since the early 1990s — is questionable, at best.

Disinflation actually began in the early 1980s — well before inflation targeting was invented —– thanks to the concerted efforts of then Federal Reserve board chairman Paul Volcker.

From the 1990s, globalization — and China’s integration into the world economy in particular — has probably been the main reason for the decline in global inflationary pressure.

A more recent indication that inflation targeting has not caused the disinflation seen since the 1990s is the unsuccessful effort by a growing number of central banks to reflate their economies. If central banks are unable to increase inflation, it stands to reason they may not have been instrumental in reducing it.

Role of Central Banks

The fact is that the original objective of central banks was not consumer price stability; consumer price indices did not even exist when most of them were founded. Central banks were established to provide war financing to governments. Later, their mission was expanded to include the role of lender of last resort.

It was not until the excessive inflation of the 1970s that central banks discovered — or rediscovered — the desirability of keeping the value of money stable.

But how to measure the value of money? One approach centers on prices, with the consumer price index (CPI) appearing to be the most obvious indicator. The problem is the relationship between money supply (which ultimately determines the value of money) and prices is an unstable one.

Monetary Policy

Monetary policy has been shaped by an imprecise, small and shrinking subset of prices. The lags with regard to changes in money supply are long and variable.

Unfortunately, the effort of monetary policy makers to operationalize the objective of ensuring the value of money remains stable has taken on a life of its own. Today’s economics textbooks assume that a primary objective of central banks is to stabilize consumer prices rather than the value of money.

Furthermore, economists now understand inflation as a rise in consumer prices, not as a decline in the value of money resulting from an excessive increase in the money supply. Making matters worse, central banks routinely deny responsibility for any prices other than consumer prices, ignoring that the value of money is reflected in all prices, including commodities, property, stocks, bonds, and exchange rates.

Central banks’ exclusive focus on consumer prices may even be counterproductive. By undermining the efficient allocation of capital and fostering mal-investment, CPI-focused monetary policy is distorting economic structures, creating moral hazard and sowing the seeds for future instability in the value of money.

Within a complex and constantly evolving economy, a simplistic inflation targeting framework will not stabilize the value of money. Only an equally complex and highly adaptable monetary policy approach — one that emphasizes risk management and reliance on policy makers’ judgment rather than a clear-cut formula — can do that.

Such an approach would be less predictable and would eliminate forward guidance, thereby discouraging excessive risk-taking and reducing moral hazard.