Slightly abridged version of "Inflation, Deflation and Monetary Policy", 19 January 1999.

Could it be Keynesian theorists got it wrong?

© Keith Rankin, NZ Herald, 20 January 1999


Paul Jackman's reply. My rejoinder [not submitted for publication].


The latest inflation statistic - a fall in the Consumers Price Index (CPI) of 0.8% in the last quarter of 1998 - may be more than a fluke. It raises the possibility that the 21st century may be more like the 19th than the 20th.

Deflation rather than inflation may prove to be the norm. In the 19th century, the world went through two industrial revolutions, both during sustained periods of falling prices.

From the 1930s to the 1960s, we grew to associate deflation with the 1930s' Depression, and inflation as a result of an overstretched economy. From the 1970s, we came to see inflation as an economic monster that could never be reversed (deflation), only tamed (disinflation). Confounding all historical precedent, inflation got worse as unemployment became endemic.

Yet, as 1999 begins, inflation has ceased. And it seems to have been disappeared throughout the developed world, regardless of the differences in monetary policy in different countries. Some, such as ourselves, have low growth and stable prices. Other countries, such as Australia and the United States, have high growth and stable prices.

Comparing Australia with New Zealand, there appears to be a much stronger link between high interest policies and low growth rates, than between such policies and low inflation rates.

Before considering the impact on inflation of a policy touted as a cure for inflation, it is necessary to have some idea of what patterns of inflation and deflation occur in the absence of such policies.

It is known that economies grow in a rhythmic rather than a steady fashion. One of the classic economics books of this century was called Business Cycles, written in 1939 by an Austrian born Harvard University economist, Joseph Schumpeter.

He identified three basic rhythms or cycles in modern economies: an inventory cycle of about 3 years, an investment cycle of just over 10 years, and a long wave cycle of about 50 years (or two generations). He explained the Great Depression of the early 1930s as having less to do with policy than with the underlying rhythms of industrial economies. The early 1980s were similarly difficult years, which saw these cycles all in a down phase.

Growth patterns in New Zealand throughout this century generally conform with Schumpeter's model. [See my "Cycles of Growth", December 1998.] If this 20th century growth pattern continues, we will experience a short recovery in 1999 and 2000, another recession in 2001, and a period of sustained growth through until about 2008.

Schumpeter's analysis also suggests that the industrialised world faces long periods of alternating inflation and deflation, with deflation being predominant during periods of revolutionary technological change.

The experience of "stagflation" (simultaneous recession and inflation) in the 1970s and 1980s seemed to invalidate Schumpeter's approach. Policymaking came to be dominated by Keynesians who believed that inflation could be cured by either higher taxes or diminished government spending, and by monetarists who wanted to use high interest rates to tame what would otherwise [in their view] be rampant inflation.

What if Schumpeter's model was an accurate representation of what the 20th century would have been like had the Keynesians and monetarists not taken over?

Schumpeter's model predicted that there would be inflation to about 1974, and deflation for the remainder of this century. In the years after 1974, world inflation rates consistently increased after restrictive monetary policies pushed up interest rates.

In the late 1980s, as world monetary policies eased, world inflation came down. New Zealand was an exception, which, following a very strong push to high interest rates in 1985, had a resurgence of inflation.

Central banks worldwide periodically used high interest rates as an anti-inflation device in the 1990s, despite absolutely no proof that high interest rates had ever created lower inflation than would have otherwise existed.

It is possible to argue that central banks' actions prevented prices from falling, whereas they thought that they were preventing prices from rising.

The mid-1990s is a good test case. New Zealand inflation had been consistently falling in the period to June 1994, and growth had been rising surprisingly quickly. Believing that growth would eventually lead to inflation, the Reserve Bank slapped the brakes on. All the statistics clearly show a rise, not a fall, in inflation for 1995-1997.

Perceptions of a world economic crisis in 1998 are proving Schumpeter right. It looks like the developed world will experience high growth and negative inflation in 1999. The world's central banks dare not act to raise interest rates, for fear of triggering a major crash on, in particular, the American stockmarket. Hence, we may be starting to see an end-of-century world much as Schumpeter would have expected.

Inflation, in Schumpeter's model, is due for a turn upwards in the first decade of the new century, so the period of deflation may be short-lived. It is to be hoped that, as growth picks up next century, our fear of inflation will have mellowed. We need to resist the temptation to grab the high interest lever whenever someone in the Reserve Bank thinks that high inflation might be just around the corner.

A return early next century to inflation rates similar to those of the 1960s should be no cause for panic.


Infiltration [sic] link

letter by Paul Jackman, published in the NZ Herald on 26 January 1999


Keith Rankin appears to have inverted the causal relationship between interest rates and inflation, suggesting that. when interest rates go up that causes inflation. He then implies that if central banks would stop meddling, we could all enjoy low interest rates, substantial economic growth and price stability.

In fact, the record shows that lower interest rates stimulate economic activity and that when an economy becomes so stimulated shortages become widespread and generalised inflation accelerates.

Interest rate rises and falls are included in the consumers price index and, therefore, an interest rate rise causes that particular measure of inflation to rise.

However, the Reserve Bank's inflation target is expressed in the so-called CPIX, which is the CPI excluding the cost of credit services, which is mainly interest.

CPIX measures of inflation are used by inflation-targeting central banks around the world and Statistics New Zealand will be changing CPI inflation to exclude the cost of credit services this year. This will partly remove the perceptual anomaly behind Mr Rankin's concern.

The more interesting point in Mr Rankin's essay is the idea that we are now entering a long period of very low or zero inflationary pressures, combined with substantially increasing economic output. It is to be hoped that this is correct.

However, that does not mean central banks will be able to avoid having to make monetary policy decisions. That will remain for as long as nations or regions have currencies.


Paul Jackman,
Corporate affairs manager; Reserve Bank.


rejoinder: Interest Rates and Inflation


Rankin File