Is it a mistake to focus on inflation?

Readers question: should the government focus on achieving a particular macroeconomic objective over the others?

This is a good question. There is a lot that can be said because it encompasses so many different topics.

Firstly, the three main macro-economic objectives:

• Higher economic growth
• Low inflation
• Low unemployment

There are also less important objectives

• Reducing government borrowing
• Satisfactory balance of payments
• Stable exchange rate
• Protecting the environment

In this post, I will just consider whether  inflation should be seen as the over-riding primary macro-economic objective

Many economists (and Central Bankers) have often stated that low inflation should be the primary macro-economic objective. They argue

• Low inflation is essential to long term economic prosperity. If inflation is brought under control, then the stability will encourage firms to invest and consumers to spend.
• If inflation is too high, then it may require lower growth and higher unemployment in the short term. But, this temporary fall in output is worth the long-term benefit of bringing inflation under control.
• In the long-term there is no conflict – if you keep inflation low, then we will also see strong growth, low unemployment and more competitive exports (helping balance of payments.
• For example, in 1980, the new Conservative government promised to tackle the high inflation of the 1970s – They used deflationary fiscal and deflationary monetary policy. Inflation did fall, but it caused a severe recession, unemployment rose to 3 million. (In 1981, 365 economists wrote a letter to the Times saying the government should change approach). But, Mrs Thatcher argued she had to stick to the course to rid the economy of inflation.
• 10 years later, there was another similar experience when the Conservative government again raised interest rates to tackle inflation, leading to another recession. In 1991, the chancellor Norman Lamont wrote

“Rising unemployment and the recession have been the price that we have had to pay to get inflation down. That price is well worth paying.”

– Norman Lamont, Chancellor of the Exchequer. 16th May, 1991 (Hansard) (Unemployment a price worth paying for low inflation)

ECB and their objectives

More controversially, since the credit crisis of 2008, the ECB have appeared to have an over-riding objective to keep inflation low – even though economic growth in Europe has been poor. To many it seems the ECB have been too concerned about low inflation, and have been ignoring other macro-economic objectives, such as economic growth and unemployment. This explains the reluctance of the ECB to pursue quantitative easing (until very recently). It explains why growth in Europe has stalled, and unemployment has increased to 12% – double the rate of the UK and US.

Low inflation as a false goal

In this particular circumstance it is arguably a mistake to give undue importance to inflation. Europe desperately needs higher growth, and higher inflation to help

• Reduce unemployment
• Avoid the threat of deflation
• Reduce real debt burdens through increasing cyclical tax revenues
• Higher inflation would also enable southern Europe countries in the Euro to restore competitiveness without prolonged deflation.

Some economists argue that in the current circumstance of a liquidity trap and stagnant economy, we actually need a higher inflation rate to help improve growth.

Macro-economic objectives depend on the circumstances

There are times, when low inflation could be a desirable goal. If growth is too fast and unsustainable, then using monetary policy to reduce inflation and stabilise the rate of inflation can help to prevent an unnecessary boom and bust.

Low inflation is generally desirable. There are many good reasons to target low inflation in the long term.

However, it is also a mistake to target low inflation and ignore other objectives, which are potentially more important. Arguably the social and political costs of mass unemployment are much greater than a moderate inflation rates. Also, moderate inflation (4-10%) is not good, but also reasonably easy to reduce. The costs of deflation are much higher, and possibly much more difficult to solve.

Related

• Should low inflation be primary objective?
• Conflicts of macro-economic objectives