Is inflation unconstitutional? Or, the future of monetary policy
An English translation of the Czech original, made with AI. The Czech text remains the record of what was written: Je inflace neústavní? Aneb budoucnost měnové politiky.
It is possible to radically change even a practice that has worked for years and invokes the constitution. We saw as much yesterday, for instance, when the Constitutional Court lobbed a grenade into the established electoral system. And it can lob a similar grenade at any time into the policy of the Czech National Bank (CNB), which also invokes the constitution.
The question is this: does a yearly rise in prices amount to price stability? The CNB's constitutional task, after all, is to maintain price stability, not to ensure positive inflation. But the CNB is not alone in this; all of central banking is due for a review.
Central banks in small economies today work from a three-part recipe. First, they aim for inflation of around two percent. Second, they pile up foreign currency and park it mostly at no return. Third, in a crisis they buy up bonds or weaken the currency. The experience of the past decade and new research, however, call all three ingredients into question. What will monetary policy look like at the end of the decade?
Genuine price stability
Most central banks are tasked with maintaining price stability. None of them, however, reads the mandate literally; instead they target two percent inflation. Mild price rises, we are told, help the economy. To a layman the logic does not add up: we do not shorten the meter by two centimeters a year either, to cut fuel consumption per hundred kilometers. Yes, we would meet emissions standards more easily on paper, but in practice there would be chaos. In the same way, the koruna is a basic unit of measurement, and changes in its value complicate life for all of us.
The academic literature on optimal inflation shares this view. According to the US Federal Reserve's database, 220 studies on the topic have been published over the past 30 years. The average estimate of ideal inflation? Minus 0.06 percent, which is to say close to genuine price stability. Little wonder that genuine stability is now championed by authorities such as John Cochrane, a former president of the American Finance Association. The consequence will be a faster-appreciating koruna, but without harm to exporters, whose costs will grow more slowly once inflation is wiped out.
Investing the foreign exchange reserves
The Czech Republic holds enormous foreign exchange reserves, more than EUR 135 billion, kept mainly in bonds. Economists currently disagree on whether advanced countries need reserves at all. The CNB did not use them in either the financial crisis or the Covid crisis. Even so, it would not be sensible for it to spend all its euros on, say, apartments in Athens or the Chinese yuan. The reserves would no longer be liquid, that is, quickly usable to defend the koruna. But there is no reason not to invest half of the euros, gradually, in quality global stocks.
In a modern economy, stocks are about as liquid as government bonds. Yet over the long run they earn around 6 percent in real terms, while bonds now often carry a negative interest rate. The state does not die; it has an infinite investment horizon and can ignore short-term swings in share prices. Singapore, after all, invests its reserves in a similar way. It is not the end of capitalism: we would be buying global stocks, where we are a drop in the ocean. The Czech Republic would merely pick up the hundreds of billions of koruna it now leaves lying on the sidewalk. Nor is there anything to stop the CNB from buying more gold, too, and filling its empty vaults. Gold does not earn much over the long run, but unlike government bonds, at least it does not lose as much.
Direct support for consumption
In a crisis, central banks rely on negative rates, weakening the currency, or buying bonds (so-called quantitative easing). A few years ago I believed in these tools myself, but the data are unforgiving. Negative rates do not help support lending. Quantitative easing has a negligible effect on inflation. Our own experience with interventions shows that weakening the currency gives the economy a push but does little to move prices.
After the financial crisis we expected a deflationary spiral. It never arrived, anywhere, regardless of whether central banks used unconventional tools, or which ones. Genuine price stability apparently has no need of such tools. If we absolutely had to use one, let us reach for one that is understandable, positive and effective. That is direct support for consumption: sending the money earned by investing the foreign exchange reserves straight into citizens' accounts. Households, not speculators, would then be the ones to profit from the CNB's loss on an unconventional tool.
A task for 2021
Central banks will adopt these improvements on their own, but it will take years. If we want change in the Czech Republic sooner, it is enough to refine the Act on the CNB by adding the following three sentences. First, price stability means stability of the consumer price index. Second, the CNB manages the foreign exchange reserves with due managerial care. Third, to achieve price stability, the CNB may exceptionally send money directly to citizens.
First published in Hospodářské noviny, 4 February 2021. Original publication.