Stephen King: Low inflation isn't everything: just ask a Twenties flapper

It's time, I think, to ask some really fundamental questions about the conduct of economic policy.

Until the middle of last year, most countries happily adhered to what is still regarded as the conventional wisdom. Monetary policy was aimed at the achievement of price stability. Fiscal policy was conducted in conservative fashion: under no circumstances was it to undermine monetary policy. Exchange rates were either allowed to float freely or, within the euro, were permanently fixed. Markets, meanwhile, would allocate goods, services, labour and capital in the most efficient possible fashion. And we could all live happily ever after....

Ah yes, how wonderful that all sounds. Sadly, though, we now seem to have entered a completely different world. The implosion in financial markets has unleashed a particularly malevolent economic virus which threatens to throw the US, the UK and possibly the eurozone into recession.

This was not supposed to happen. Policymakers the world over hoped they'd found the holy grail of economic policy, the solution to all their previous problems. Instead, they've ended up with a collective sore head.

To my mind, the problem lies partly with the blind devotion to inflation targeting. Admittedly, this is a sacrilegious view which won't find favour with the high priests of the central banking community. Nevertheless, inflation targeting is not, and never was, the cure for all our economic ills. To understand why, we need to go back in time....

It's 1920s America. The Great War is long forgotten, the economy is roaring, the stock market is booming, the speakeasies are humming and the girls are flapping. Where, though, was the inflation? There wasn't any. Remarkably enough, despite the party atmosphere and the short dresses (allegedly a barometer of economic welfare), price pressures were absent. Does that mean policymakers got things right? Were the 1929 Crash and the Depression which followed just unfortunate events for which policymakers in the 1920s had no responsibility? Or did the absence of inflation merely offer a false sense of security?

It's now late-1980s Japan. The Americans are feeling twitchy. Japanese car companies are making huge in-roads into the American car market. The Japanese have bought the Rockefeller Center. Japanese banks are the biggest in the world. In the shops of the Ginza and the clubs of Roppongi, shoulder pads are ever larger. The stock market is booming and land prices are soaring. And yet there is no inflation. Indeed, in the late 1980s, Japan's inflation rate was among the lowest in the G7. Inflation did, eventually, rise but it never got beyond 4 per cent, a rate which, in those days, was small beer.

Did Japan's subsequent financial bust and ongoing subsequent stagnation have nothing to do with the economic policies of the 1980s? Was the absence of inflation really a sign that Japan had entered a new phase where you were either rich or even richer?

At the very least, history shows that the achievement of price stability, even if a necessary condition of lasting economic success, is certainly not a sufficient condition. Even this conclusion, though, seems a little weak. I think we need to probe a bit further. What exactly is meant by price stability? And how do we know when it has been achieved?

US consumer prices may have been stable in the 1920s, but assets prices certainly were not. The same applies to Japan in the 1980s. Does this mean, then, that central banks are too narrowly focused, looking only at consumer prices while, for the most part, ignoring the impact of rapidly rising asset prices? Quite possibly, but I'd go still further. There are times when central banks should allow consumer price inflation to diverge from its medium-term objective to ensure price stability on a much broader metric. Sometimes, the divergences should be both large and lengthy.

Let me offer some examples. Suppose there's a beneficial supply-side shock elsewhere in the world which will last for, maybe, four or five years. Imagine, for example, a big improvement in technology, a halving of oil prices or the integration of a low-cost producer (China, let's say) into the world economy. These sorts of events lead to lower import prices which, in turn, provide a terms-of-trade improvement.

The best way for this improvement to be delivered is to allow prices to fall relative to wages, profits and interest rates. This is what I'd call "good deflation". Most people are better off, no one is living beyond their means, and there's no underlying distortion to capital markets.

But what happens if the central bank has an inflation target? Its policymakers will presumably look at the price declines with a degree of unease. Their mandate, after all, leaves little room for flexibility in dealing with external price shocks. They feel obliged to cut interest rates.

What, though, do they achieve by doing this? They're effectively creating "bad" domestic inflation to offset the "good" imported deflation. In the process of doing so, they leave real (inflation-adjusted) interest rates too low, spawning the beginnings of an asset price boom, perhaps in equities or maybe, instead, in housing. Moreover, by lowering the return on cash, investors become increasingly enthusiastic about higher-returning, but possibly more risky, assets. Mortgage-backed securities are but one example.

Now turn the argument on its head. Imagine an unfavourable external shock. Perhaps oil prices go up a long way or, instead, maybe food prices are unusually high. The natural reaction of a conservative central bank is to shove interest rates up as fast as possible (or, as with the Bank of England currently, to cut interest rates only very slowly). It will worry that higher oil prices might, in turn, lead to bigger wage demands and the beginnings of a 1970s-style wage-price spiral. What happens, though, if wages don't respond? After all, globalisation simultaneously places downward pressure on western wages – more competition from China, India and others – and upward pressure on commodity prices – more demand from China, India and others.

In these circumstances, the rise in oil or food prices acts as a natural demand suppressant. If wages and profits are unable to respond, spending power will, in real terms, be restrained, leading to lower demand and weaker activity. A central bank which shoves rates up aggressively (or, in the midst of a banking crisis, is slow to cut) will simply make a chilly economic situation even frostier.

The rigid adherence to an inflation target in a world of constant external shocks may sometimes be more a source of instability than of tranquillity. With sizeable relative price shocks stemming from globalisation, the risks of instability are all the greater. Even worse, if the public thinks that price stability is the only litmus test of economic health, the achievement of low inflation may encourage excessive risk-taking which, in turn, could undermine the achievement of broader economic objectives.

Central banks are, of course, not the only source of economic instability in an ever-more-complex world, but the blind pursuit of consumer price stability at any cost is unlikely to prevent the major financial upsets which plague economic development. Just ask that 1920s flapper, newly impoverished in the early 1930s.

Stephen King is managing director of economics at HSBC

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