Inflation Targeting and Asset Bubbles

A recent op-ed by Christopher Linglein in the Jakarta Post;

A second flaw in the notion that stable and predictable price increases can be "neutral" with respect to the real economy is in ignoring "bracket creep" for tax liabilities. When incomes rise to compensate for lost purchasing power from a rising price level, individuals may face higher marginal tax rates.

Predictable, consistently-rising ("stable") prices can lead to "phantom" capital gains that reflect rising prices rather than a change in real scarcity. Actions taken to avoid higher tax liabilities tend to reduce the availability of capital. And higher marginal tax rates weaken work incentives that tend to reduce overall labor supply.

Unfortunately, most central bankers think of inflation in the narrow terms of rising consumer prices as measured by an arbitrary indicator like a consumer price index (CPI). But a rising CPI is just one of several possible results of rapid growth in the money supply. Asset bubbles, an increased trade deficit and a depreciating currency are others. All are caused by an inflated money supply, even when the target for a "stable" CPI is hit.

And so a failure of inflation targeting is that it does not and cannot halt asset bubbles. Increased liquidity during the 1990s allowed asset prices to rise without pushing up consumer prices significantly since global competition weakened corporate pricing power. More recently, commodity prices have been rising rapidly even though consumer price rises have remained relatively tame.

Inflation targets guide central bankers on how to implement monetary policy to stabilize prices rather than to minimize the effect of changing relative prices on the real economy. Despite its promise, inflation targeting has contributed to financial instability and asset price bubbles. It would be better for central banks to put tighter controls on monetary indicators such as money growth and credit growth.