Central bank’s role in dealing with inflation

Author talks about the vital role of money supply.

RIYADH: All the economic textbooks I have come across say that price stability is the key objective of any central bank policy. But there was none which digressed why it is so. Here I attempt to explain as briefly as I can why hyper-inflation is doomsday, deflation a potentially malignant tumour and double-digit inflation, a call for war.

Inflation occurs when more money chases the same number of goods.

Since modern day central banks have the right to issue new currency notes, the signals they can send through money is absolutely critical. Hyper-inflation or a phenonomenal increase in prices can destroy economic activity because money ceases to be a medium of exchange and we progress towards barter or less efficient forms of exchange such as gold. The famous cases include Germany post-World War 1 and currently Zimbabwe. Prices in Germany were doubling almost every second day in 1923, while Zimbabwe prices rose by 1.1 million times in June 2009 over the last year. In both cases, the government borrowed excessively from the central bank

World economic output had grown between 3-4% annually in real terms in the last 100 years. Increasing money supply in line with this growth is another fundamental of central banks. This is nowhere as easy as it sounds. Economic growth is difficult to measure accurately, government borrowing pressures, policy time-lag coupled with consumer confidence and expectations.

If lets say the real economic output grew by 3% and the central bank did not increase money supply at all, we would have fewer money chasing larger number of goods which would most likely lead to fall in prices, technically known as deflation. Deflation can also be caused by a fall in asset prices, such as stock market or real estate values, which affects consumer spending and investment confidence, which along with government’s spending and exports (net of imports) forms the Gross Domestic Product (GDP).

If prices are expected to fall, companies will be reluctant to borrow even at zero interest rates as they will get lower prices from selling products in the future and hence lower profitability, in which case they might as well hold cash.

To protect against this threat of deflation, moderate inflation probably between 2-4% is considered ideal. It gives a signal to companies that aggregate demand is strong, encourages investment, while at the same time benefiting borrowers somewhat. That is why central banks’ money supply growth is usually more than growth in real output (GDP). This rate of inflation, usually found in developed countries, gives a sense of price stability, keeps economic planning easy and avoids an inflationary spiral.

So why can double digit inflation be referred to a call for war? Well at that point inflationary expectations get entrenched. The devaluation of money is great enough for individuals to feel the pinch and demand pay hikes. To counter these higher costs, companies increase product prices, and the rate of inflation continues to increase. To prevent inflation from getting out of hand, interest rates or the ‘cost of money’ has to be raised so people borrow to spend less. However interest rates in the range of 10% or more make very few new projects viable, thus increasing real output (GDP) at a slower rate and encouraging investment in unproductive assets such as gold.

High rates and low growth may stay in place for years as it is difficult to break ‘inflationary expectations’. In Turkey, inflation rate was above 40% annually, interest rates above 50% and real GDP growth of meagre 2.2% between 1980 and 2000. And growth matters when you think of it because most people want real increments or a rise in living standards at the end of each year.

As you can well see, money is what the world should revolve around and does so. At the same time, it is imperative for central bank, helped by prudent fiscal policies, to maintain price stability. It is like a game which has to be continuously played.

The writer works as an economist and portfolio manager.

Published in The Express Tribune, April 2^nd, 2012.