Expect rather stable consumer price inflation – but not because of succesful central bank management
In 1910 the index of the USA consumer price level (1982-1984 = 10,000) was equal to 921, not much above the 1774 level of 782. This seems to indicate very low and stable consumer price inflation in this gold-standard period – until we notice that the 1778 level was equal to 1338, almost double the 1774 level (yes, this was due to the American revolutionary war). Sustained high inflation was not uncommon during the period of the gold standard, especially during wars (graph 1, which shows Year on Year changes of the consumer price level as well as a five-year moving average). Collateral information: notice that in the twentieth century, high inflation continued for one or two years after mayor wars.
After these bouts of inflation, however, there was some kind of reverse to the mean and protracted periods of deflation followed (some downward stickyness of prices?). Which shows that any analysis of inflation should make a distinction between the short and the long run. Which is what central banks do – they aim for low as well as stable inflation. When we restrict ourselves to the stability of inflation we can ask the question: did the central banks deliver? Is inflation less volatile than it used to be?
The answer is yes (graph 1): differences in inflation between subsequent years are a lot smaller than they used to be. Graph 2 and 3 show more precise estimates of volatility: ten-year rolling estimates of the ‘coefficient of variation’ (a kind of the level of average change) of the price level as well as the coefficient of variation of inflation, for graph 3 absolute values of price changes have been used to calculate the coefficient). Graph 2 shows that (taking 10 year periods) the amount of change of the price level hasn’t changed too much during the last 240 years. The price level changed as much as in recent decades – though also in a downward direction (the thirties!). Graph 3 however shows that the rate of change has become much more stable (mind: the uptick of volatility at the end is caused by lower inflation). This trend started after 1960 and is, in my opinion, might not be due to succesful central bank management but to changes in the ‘basket’ of consumer goods used to calculate consumer prices: a lower weight for volatile food prices, a higher weight for less volatile house rents. Which means that people can expect more stable inflation, regardless of central bank policies (unless new products or services entering our consumption basket cause volatility to rise).
Addendum: Michael Woodford, the present kingpin of neoclassical monetary analysis, states that, by definition, changes in relative prices (including house prices and other asset prices) enhance prosperity as an economy with perfectly flexible prices will always be in optimal equilibrium which means that a central bank should “not” (emphasis not added) take regard of asset price changes, as asset prices are quite flexible. Look here, especially chapter 1. His model however does not allow for asset price increase related flow money creation and Ponzi lending (i.e. the sub-prime bubble, Ireland, Spain, the Netherlands) and the subsequent increase of increasingly risky stocks of household and company debt. Which, considering that he aims to explain the price level and inflation and to investigate how central banks have to act to prevent economic turmoil, simply means that he has to totally overhaul and rewrite his famous book – among other things by adding more economic history, more than a little bit of Minsky and endogenous money. At this moment, his policy prescriptions are outright dangerous. The ECB has, recently and fortunately, exempted lending for house purchase from it’s targeted Lont Term Refinancing Operations, which is totally at odds with Woodfords prescriptions. He should acknowledge this.