Low, stable inflation helps the economy operate efficiently

The argument

Low, stable inflation provides individuals with more monetary stability and purchasing power, and on this argument that stability is the mechanism through which the wider economy comes to operate efficiently. When the value of money holds, the reward for deferring consumption is predictable, which helps the economy move towards stability and thereby encourages individuals to save and invest rather than spend defensively against an expected loss of value. According to economist Richard G. Anderson, price stability is "a prerequisite for attaining maximum sustainable economic growth." The reasoning behind that claim concerns information as much as money. Having low, stable inflation reduces economic volatility, and where volatility is low the prices and interest rates that economic actors observe today remain reliable guides to what they will face later. Businesses and households can therefore make more accurate longer-run financial decisions about borrowing, lending, saving, and investing — decisions whose value depends on the assumptions behind them still holding years after they are made. Capital is committed to the projects with the best expected return rather than withheld against uncertainty, and that is what efficient operation means here. Anderson also claims that sustained low inflation is necessary for an economy to achieve long-run economic growth, and proponents note that the effects are not confined to one country: they are experienced in the United States and abroad, since the same predictability governs decisions wherever the price level is stable. A further consequence runs through the cost of capital. By having low, stable inflation, longer-term interest rates are more likely to be moderate, because lenders need not demand a large premium to insure themselves against future erosion of the money they are repaid in. Because a stable price level makes long-horizon decisions calculable and keeps long-term borrowing costs moderate, the argument concludes that inflation targeting provides monetary stability.

Premises

Counter-arguments

The argument supports the value of low, stable inflation without supporting the target actually under discussion. Nothing in it explains why the figure should be 2% rather than 1% or 4%, or why an inflation rate rather than some other nominal variable should be the object of policy. The number was not derived from theory: it entered central banking through New Zealand's initial price-stability legislation and was copied internationally. Anderson's claim, taken literally, points somewhere else again — if price stability is a prerequisite for maximum sustainable growth, that is an argument for zero inflation, which a 2% target deliberately does not deliver, so the authority cited does not support the position it is enlisted for. The argument also assumes the target delivers what it promises. Critics observe that major central banks undershot 2% for years after 2008 despite extraordinary measures, and then overshot it substantially, which suggests the target expresses an intention more than a capability — the contention of the second sibling position. A met target is compatible with instability accumulating elsewhere, too: consumer prices were stable through the years in which housing and credit imbalances built up before 2008, which is the basis of the remaining sibling position that a nominal GDP path would better capture what stabilisation is for. And the argument's own mechanism cuts against it at the margin, since an inflation rate low enough to keep long-term interest rates moderate also leaves little room to cut them in a downturn before reaching zero — the constraint that has prompted proposals to raise the target rather than defend it.

Rejecting the premises

[Rejecting P1] Low, stable inflation may aid planning, saving and investment, but nothing here explains why the target should be 2% rather than another figure, or why inflation rather than another nominal variable should be targeted. [Rejecting P2] Read literally, the claim that price stability is a prerequisite for maximum sustainable growth argues for zero inflation, which a 2% target deliberately does not deliver — and stable consumer prices coexisted with the credit and housing imbalances that preceded 2008, so meeting the target does not secure stability.