Inflation Targets

Countries around the world hold a ‘low and steady’ level of inflation as sacrosanct. The USA announced this February that its inflation target would be 1.7-2% while the Bank of England has long sworn by its target of 2%. There are many reasons why people support these low targets. For one, those on fixed incomes are relatively protected as their real income isn’t greatly reduced. The low rate of inflation also allows time for the incomes of those people to respond. Also, high inflation may cause unions to lobby for higher wages, pushing up the costs of firms. This would reduce the competitiveness of exports – adversely affecting the balance of trade. As a result, there may be unemployment and the start of the negative multiplier effect.

However, there is a case for inflation targets to rise. Heavily indebted countries would benefit as the real value of their debt decreases. However, while doing so would rebalance the current account they could well alarm the creditor. A higher target rate of inflation would also justify the central bank cutting interest rates. As a result, people will take out more loans and be less inclined to save. Such expansionary monetary policy would spur economic growth and cause demand-pull inflation.

In addition, if the government announced an inflation target that is higher than usual, people may be compelled to expedite purchases that they had planned to make at a later date. This increase in consumer demand would not only serve to make firms employ more workers, but would lead to economic growth as firms expand their output.

Decreasing interest rates to push up inflation will also devalue the currency due to the increase in money supply and demand. This will cause exports to be more competitive. Consequently, the balance of trade may actually become more favourable as a result of inflation – contrary to the view expressed above by advocates of low inflation targets.

As mentioned above, one of the main arguments against targeting high levels of inflation has been that such high levels cause unemployment as firms can’t afford to hire as many workers at higher wages. However, if inflation is achieved through demand-side policy, rather than firms having to cut back on output and employment, they will need to increase employment – even at the higher wages. Hence, a higher level of demand-pull inflation may result in a decrease in unemployment. Moreover, even if firms need to reduce their labour costs, it is unlikely that they will need to lay off that many workers. This is because they will be able to mask real wage decreases by increasing wages at a rate lower than inflation.

In addition, if the government announced an inflation target that is higher than usual, people may be compelled to prepone purchases that they had planned to make at a later date. This increase in consumer demand would not only serve to make firms employ more workers, but would lead to economic growth as firms expand their output.

Furthermore, it is obvious that those who are hardest affected by rising inflation are those on fixed incomes such as pensioners and the unemployed. However, if there was higher inflation then there is likely to be a decrease in voluntary unemployment – a decrease in the number of people who choose to be unemployed because the unemployment benefits are generous enough that they have little incentive to work. This would be beneficial to the economy as it would lower the output gap and stimulate economic growth. Now, at first thought, many would assume that voluntary unemployment barely accounts for a fraction of total unemployment. However, in the US, voluntary unemployment has been hovering at between 10-15% over the last couple of decades. Clearly, it is a problem that needs to be tackled and inflation could be one way of doing so.

All in all, it seems that perhaps current inflation targets are too conservative. Countries clearly stand to gain from an increase in inflation targets. Unfortunately, such measures are unlikely to be put into practice as they hit pensioners the hardest. And pensioners, rather than younger people, are the ones who tend to vote.

Japan's Escape

Japan’s economy has been in a period of stagnation ever since the ‘lost decade’ of the 1990s. For the past year or so, consumer prices have continued to fall. The continued fall has meant that consumers have put off buying in hope of cheaper prices in the future. This has created a vicious cycle of falling profits for firms and falling wages. This collapse has only been accentuated by the fact that Japanese firms have reduced investment because of low confidence in future demand.The question now is how will it get out of this mess?

Clearly, Japan must increase confidence in the economy and it must do so by stimulating demand. One way it could do this is by lowering the income tax (which can be as high as 40%) to stimulate consumer demand and raise prices. Despite the fact that this would increase the budget deficit, I feel that this fiscal reform is necessary if the crisis is to be halted.

Recently in Japan, the increase in the output gap has been closely correlated with falling consumer prices, with a slight lag. The output gap stands at around 7% of GDP today. It follows that, if Japan could shrink its output gap (the difference between actual GDP and GDP if all work-eligible people and factors of production were employed), it may be able to escape deflation. I feel that a reduction in corporate tax – which is high at 30% - is in order. This is likely to increase investment by firms – creating jobs and therefore reducing the output gap. The creation of jobs will also serve to increase aggregate demand – potentially pulling Japan out of deflation. Though, again, the reduction in corporate tax will further increase the budget deficit in the short-run, I feel that the increase in tax revenues from newly created jobs and higher profits will make up for this in the long-term. In other words, I believe that the Japanese government has implemented a tax rate that is beyond the rate at which they would achieve greatest tax revenue. This can be illustrated on the Laffer Curve below where the current rate is b% and government tax revenue could be increased by reducing the tax rate to a%

One of the most pressing problems that Japan faces is its changing demographic. With one of the lowest birth rates in the world and a shrinking working class, it is no wonder that demand is shrinking. And this is exacerbating the deflation. What Japan needs to do is relax its strict immigration laws to increase the workforce and bolster demand – an average of 381,000 foreign workers per year will need to emigrate to Japan (through until 2050) to keep the population stable. What’s more, the Japanese government will have the added benefit from the immigrants of increased tax revenue.

I believe that if the Japanese government loosened immigration controls and adopted fiscal reforms to narrow the output gap, they will be able to pull their country out of an extended period of deflation. Hopefully, with the elections coming up this summer, the government will adopt these measures to tackle the problem and regain popular support.

Solving China's Property Bubble

China’s property market is getting too hot. Inflation is rampant at 11.7% and finally the Chinese government is taking steps to cool it down. The government said they would increase mandatory down-payments on second and third homes as well as on first homes larger than 90 square meters. They also plan to increase the supply in the property market through the construction of affordable small and medium sized houses. Though some of these actions are laudable, I feel that they are not the most effective set of reforms to deal with this problem.

The Chinese government has announced an increase in down payment on first homes of more than 90 square meters from 20% to 30% and an increase from 40% to 50% on second homes. The increase in mandatory down-payments, especially for the purchase of second or third homes, was intended to deter speculators. However, this reform isn’t going to be very effective as a quarter of Chinese home-buyers pay cash for their houses and the average mortgage only covers about half of the value of the property because home-buyers want to avoid paying interest. Hence, while this reform will not deter that many deep-pocketed speculators because they are paying similar down-payments anyway, it will adversely affect those people who aren’t wealthy, can’t afford large down-payments and are buying a house for their own use.

This said, the other reform adopted by the Chinese government to cool the property market -increasing the supply of houses will, in theory, reduce the equilibrium price of houses. Also, the fact that the houses are small and medium sized means that the increase in supply is aimed directly at those who are worst hit by the inflation. However, the large flaw with this plan is that building houses and apartment blocks takes a great deal of time and, by the time construction is completed, the housing bubble may already have burst.

So if increasing down-payments is actually missing the point and increasing supply will take too long to have an effect, what should the government do? Well, they have got to look at the root of the problem which is why people are putting money in the property market in the first place. In my opinion, the main reason for this is the fact that Chinese deposit rates are capped at a paltry 2.25% - not even enough to compensate for inflation which ran at 2.7% this February. If deposit rates are so low, why would anyone put money in a bank? What China needs to do to cool off the property market is raise its deposit rates so people make deposits rather than spend money inflating the property bubble.

Raising the deposit rates will have the added advantage of mitigating the effects of the imminent rise in inflation. I hear you say that China’s inflation rate is at a ‘perfect’ level of 2.7% according to the Consumer Price Index. Indeed, this rate of inflation is near-perfect but is likely to rise later in the year. We can see this from the Producer Price Index which rose at a rate of 5.2% in March as a result of an increase in commodity prices – foreshadowing inflation.

However, though raising deposit rates seems to be the ideal solution, it cannot be put into practice as the central bank cannot raise the deposit rate because of the peg on the USD. Clearly, in order to cool down the property market, the Chinese government must allow some flexibility in the price of the yuan – in turn allowing for upward adjustments in the deposit rate. The increased deposit rates will increase speculative inflows - hence the yuan will appreciate. This will rebalance the skewed trade balance with the US by reducing the competitiveness of Chinese exports. It will also bring about a structural change in the Chinese economy, making it less dependent on exports and more driven by domestic demand.

Deep Vaze

16/4/2010