IMF Tells Bankers to Rethink Inflation (wants inflation to be 4%)

The International Monetary Fund's top economist, Olivier Blanchard, says central bankers should consider aiming for a higher inflation rate than they do currently to lessen the chances of repeating the recent severe recession.

Mr. Blanchard, a macroeconomist on leave from the Massachusetts Institute of Technology, said the global economic downturn revealed flaws in macroeconomic policy, especially the reliance primarily on interest rates to manage economies. Although Japan had fallen into a decade-long funk despite low inflation and low interest rates, "most people convinced themselves that the Japanese didn't know what they were doing," Mr. Blanchard said in an interview.

Don't worry Mr. Blanchard, at the rate the U.S. and other countries are spending money they don't have, 4% inflation or higher may be coming soon.

Rapidly rising house prices, and expectations for this trend to continue, encouraged banks to issue no-downpayment mortgages and for borrowers to take them. We should have had tighter, not looser monetary policy in the 2004-2006 period.

An interview with Blanchard is here , and the paper "Rethinking Macroeconomic Policy" is here. The IMF was created in 1944 to administer the Bretton Woods pseudo-gold-standard, which finally expired in 1973 (the victim of inflation by LBJ and Nixon). The IMF should have expired then too, but government agencies always try to perpetuate themselves.

Monetary policy was already tight by 2005. From 2005 to 2008, M1 didn't grow at all, and rates rose to 5.25%, until the yield curve inverted.

Yes the Fed was marginally too loose in 2003 and 2004, but that was all over by 2005. The banks continued to lend recklessly for another year and a half, until the summer of 2007.

Fed controlled M1 has grown less than 4% annually on average since 1988. That is a 2% reduction from its long term trend rate since 1959, and well below the 7.5% rate of growth seen in broader (bank controlled) money, total assets, and total debt.

The imbalance built up from commercial banks continuing to expand faster than narrow money growth could justify. That meant real prices for assets rose, without the broad price level following suit. Those higher real prices both attracted new supply and crushed demand. This happened in housing and oil and other commodity markets.

Pretending this is all the Fed's fault is pretending. No it hasn't been systematically looser over the last generation, it has been systematically tighter. Enough so that it wrung actual consumer inflation out of the system, which reduced long term rates. Other players in markets have reacted to those lower long rates by expecting large scale inflation to result, but none has.

Implicitly, investors think themselves entitled to 8-9% risk free nominal rates, of which they expect 5-6% to be real. But there is no economic or empirical justification for this expectation. Their capital flat isn't worth that much. They are spoiled by high past rates that reflected lack of confidence in governments and central banks circa 1980, and the long move down from those panic levels.

Meanwhile, total debt growth in dollars in the last year ran 2.3%, despite treasury deficits. Because banks and other players are contracting. This is a third of the long run average rate, not above it. The Fed met the panic in the fall of 2008 with large scale issuance of high powered money, raising M1 by over a trillion dollars. But it hasn't increased its sheet since then (2% change from November 13, 2008 report to now).

It is a deflation, not an inflation. It's underlying cause is that half the world bet the house on large scale inflation, but they were wrong. They still are.

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