Monday, February 11, 2008

Should Low Inflation Be the Highest Goal for A Government?

There is an important difference between UK monetary Policy and US monetary Policy. The Federal Reserve has been given a target of low inflation and full employment. The MPC, in the UK by contrast, have only one objective - low inflation; CPI inflation of 2%.

Recent events show the difference in attitudes to Monetary Policy. In the US, concerns over falling stock markets and impending recession, caused the Federal Reserve to cut rates by 1.25% in the matter of weeks. The MPC, by contrast took a much more conservative approach cutting rates by 0.25% and adding that it still remained concerned about inflationary pressures.

Of course there are differences, US house prices are falling faster and for a long time; the prospect of recession is more significant in the US than the UK. However, if you have an objective of achieving full employment then it makes it easier to justify big rate cuts like in the US.

Advantages of Targeting Inflation and Full Employment

  • If you only target inflation, then there is a risk that you can cause a slowdown. Low inflation on its own isn't the only important objective.
  • Inflexible. Suppose there was a rise in cost push inflation. This would cause higher inflation and lower growth. (AS curve shifts to left). The MPC would be mandated to effectively increase interest rates to keep inflation low. However, this rate increase may be inappropriate and tip the economy into recession. The US, by contrast would have the flexibility to allow a higher rate of cost push inflation and avoid a significant fall in growth.

Problems with US system of Targeting both low inflation and full employment.

The Federal reserve can be criticised for responding too hastily to falls in financial markets. In 2002, the Fed cut interest rates to 1.5% in response to falling markets, arguably this created a credit and housing bubble. If they had sought to control the housing and credit bubble, rather than panicking about full employment they may have enabled a more stable period of economic growth.

There is also a criticism that by cutting rates so quickly they are throwing a lifeline to financial institutions which were reckless in lending bad credit without proper safeguards. If the Fed, try to dig bad lenders out of a hole. There is an argument it will create moral hazard and encourage future bad loans.

Low Inflation is the best long run Strategy for Full employment.

  • It is argued that if you create a low inflationary environment it provides the best solution for full employment. Low inflation enables.
  • Growth to be close to the long run trend rate,
  • Encourages investment through encouraging stability.
  • The experience of the UK economy since independence of the MPC in 1997, suggests that the UK strategy has been successful in maintaining both low inflation and full employment.
I think both can work. Often it comes down to making the right decisions rather than the framework. However, if there was a change in global economic conditions, I would be concerned about the UK's policy of targeting only inflation. There is a lack of flexibility in only targeting inflation. Hopefully common sense would prevail and the MPC would take into account the effect on growth and employment.

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