Analyse: The lure of stable prices

[blockquote]“The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware”[/blockquote]

Murray Rothbard

In his book America’s Great Depression, Rothbard wrote that central banks failed to recognise the existence of an inflationary problem with the adoption of a stable price level as the criterion for monetary policy. Mainstream economists conceive of inflation as an ongoing rise in the consumer price index (CPI). If the increase is between zero and two per cent per annum, they will speak of price stability. Mauritius has been in such a situation since May 2015 when the official annual inflation rate stood at 2.0 per cent. It fell further to 1.2 per cent in November. Basing on this estimate, the monetary policy committee has decided to lower down further the key repo rate by 25 basis points. Its members observed that “inflation did not pose any serious risks” and that “there would be limited build-up in inflationary pressures until the end of 2016.” They pointed out that “with low inflation, the real rate of interest on deposits was comfortably positive.” Yet, the Bank of Mauritius forecast that headline inflation would close the current year at around 3.0 per cent. Savings account is presently remunerated at that rate. So savers are expecting their real interest rate to be almost nil. They have no incentive to save because there will be no gain in the purchasing power of money. Spending is the order of the day. What is meaningful for economic operators is not the current level of prices but the future direction of prices. Inflationary expectations are on the rise as inflation rate will be going upwards. Instead of anchoring them, the MPC has set in motion inflation. It will maintain its accommodative monetary stance as long as the resulting inflation is not translated into the CPI. This is exactly where the problem lies. The whole notion of trying to measure inflation by a price index is out of touch with economic reality. The CPI is not an economic variable. It is a statistic computed from a weighted average of prices of goods and services of a mythical household budget. The choice of basket items is arbitrary. There is no way to establish a basket that accurately measures inflation. A basket that includes goods whose prices are falling and excludes goods whose prices are rising, results in a lower reported inflation rate. CPI measurement is fraught with practical problems. First, which prices are to be measured? Second, what weights to be assigned to what goods? Third, what to do about changes in quality? Fourth, what is the suitable price collection period? A methodology in which the goods, weightings, quality adjustments and timings play a decisive role can only underestimate the rate of inflation. Evidence is provided in the real world by symptoms of high inflation: pensioners and low-income earners complain of an erosion of their real incomes, and economic growth keeps stalling. It is often said in the media that “inflation is caused by rising prices.” But inflation is the rise in prices! Inflation occurs when the value of money decreases relative to the goods and services it can buy. A general increase in prices develops on account of an increase in money supply. Broad Money Liabilities in Mauritius are growing at a double-digit pace with an annual growth rate of 10.9 per cent in November 2015. This is truly the monetary inflation rate. The money supply will continue expanding rapidly as the rupee depreciates against the US dollar in a context where the Federal Reserve, which has just raised interest rates for the first time in almost a decade, is likely to do so again several times over the next three years. It goes without saying that excess liquidity will remain stuck in our banking system unless it is mopped up at a very high cost for the Bank of Mauritius. The comfort drawn by the latter from the quantum of excess liquidity is unwarranted, for excess cash holdings by banks climbed from Rs 5.2 billion on 11 December 2014 to Rs 9.8 billion on 10 December 2015, hence an annual increase of Rs 4.6 billion, or 88%, the average cash ratio being 100 basis points higher. These are real figures to which people give credence. By contrast, they do not let themselves be fooled by index numbers, and rightly so. Because they see prices rising, consumers and producers are not lured by the siren song of stable prices.