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Traktion

Rpi Vs Cpi Vs Monetary Inflation - Can Base Interest Rates Fix All?

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With all this talk of inflation/deflation, monetary vs price index inflation, I have been pondering.

As our only real tool to control inflation seems to be the setting of base rates (putting aside QE), I am wondering how CPI can be controlled using this mechanism. I can understand how monetary inflation can be tempered by increasing the base rate and I can understand the reverse, but CPI (and RPI) are affected by external factors too. Import prices may fluctuate due to exchange rate changes, commodity prices and so forth.

With the above in mind, how can base rates be an effective lever to control such fluctuations and may they not be counter productive? For instance, pushing up the base rate to stop CPI inflation could be counter productive - it would make credit more expensive, while import prices may be mostly unaffected. While the currency may strengthen through increased demand (for the currency), would the side effects on existing debt costs increasing not cause more problems?

Rationally, it would seem like the best way to increase demand in a currency, would be to generate industry which would increase demand for the currency. It would also seem rational for base rates to only constrain over leverage or encourage leverage depending on the state of the economy. However, using base rate changes to try to control both simultaneously (as what seems to happen when using CPI), seems to be a little strange.

Am I misunderstanding the system or is tracking an inflation index to set a base rate a throw back from a less global economy? If we were self sufficient, I can understand how CPI may be a reasonable measure (although flawed, as it seems to miss asset price inflation), but with our prices being effected as much by events beyond our control, is it still appropriate?

We have touched on some of this in another thread, but it seems like broad money (in one of its measurements) would be a better way of measuring credit expansion (ie. too much = overheating). As for attempting to shield business from external price fluctuations, would fiscal stimulus (ie. tax reductions, hand outs etc) not be the sensible action (putting aside moral hazard, whether it is wise to meddle etc)?

It looks like higher import costs may well be coming down the line, especially if our currency continues to weaken, so I would assume the existing system may well be stressed in the coming years. If we are using the wrong benchmark, the results could be disastrous. We could argue monitoring CPI has already been disastrous (HPI, then HPC etc), but maybe the worst is to come?

P.S. I'm leaving aside the points about whether there should be a central bank etc - this is meant to be purely an investigation into how the current system works and where its flaws lie.

EDIT: typo in title

Edited by Traktion

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No comments? I would appreciate any feedback from those knowledgeable in such things.

Also consider, if CPI hadn't been used over the last couple of decades, interest rates would not have stayed so low. If much of the CPI is made up from cheap imports from the likes of China, it will clearly have remained lower than it otherwise would have been. If broad money had been used instead, CPI may have fallen, due to "efficiencies" abroad (read: cheaper, Chinese labour) bringing down prices. How could this be a bad thing? Why should interest rates be used to combat such benefits?

You could argue that interest rates needed lowering to help compete with China et al, but borrowing cheap money indefinitely is no long term solution either. Basing policy on China one day not being so cheap, while trying to sandbag with cheap credit seems like a foolish idea - they may (will?) stay cheaper for longer than we can stay solvent, especially with a currency pegged to the dollar. No, it would seem to me that efficiencies would need to be made here too, to compete, via automation or wage cuts. I would assume automation would be better, allowing people to retrain into other industries etc.

Which brings me back to the first question - why is CPI a good benchmark for setting interest rates when there appear to be better alternatives?

edit: typo

Edited by Traktion

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No comments? I would appreciate any feedback from these knowledgeable in such things.

Also consider, if CPI hadn't been used over the last couple of decades, interest rates would not have stayed so low. If much of the CPI is made up from cheap imports from the likes of China, it will clearly have remained lower than it otherwise would have been. If broad money had been used instead, CPI may have fallen, due to "efficiencies" abroad (read: cheaper, Chinese labour) bringing down prices. How could this be a bad thing? Why should interest rates be used to combat such benefits?

You could argue that interest rates needed lowering to help compete with China et al, but borrowing cheap money indefinitely is no long term solution either. Basing policy on China one day not being so cheap, while trying to sandbag with cheap credit seems like a foolish idea - they may (will?) stay cheaper for longer than we can stay solvent, especially with a currency pegged to the dollar. No, it would seem to me that efficiencies would need to be made here too, to compete, via automation or wage cuts. I would assume automation would be better, allowing people to retrain into other industries etc.

Which brings me back to the first question - why is CPI a good benchmark for setting interest rates when there appear to be better alternatives?

Because it lets them steal more.

They don't just have interest rates btw - theres a whole raft of regulation, legisslation, arm twisting - nudges to the banks as to what sectors to lend to, what sectors to deny and so on that they get up to.

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Because it lets them steal more.

They don't just have interest rates btw - theres a whole raft of regulation, legisslation, arm twisting - nudges to the banks as to what sectors to lend to, what sectors to deny and so on that they get up to.

So Gordon Brown chose CPI for the "independent" BoE to use as he wanted the banks to steal more? Either he was misguided or evil, if this was the case.

I could imagine the government meddling has a big affect already, but then at least that has some sort of targeted (if misguided) reasoning behind it. What I can't understand, is why CPI was used to set base rates from - am I missing something (other than the state being evil)?

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So Gordon Brown chose CPI for the "independent" BoE to use as he wanted the banks to steal more? Either he was misguided or evil, if this was the case.

No, the "independent" government with Gordon Brown at the head of it was chosen by the central bankers.

I could imagine the government meddling has a big affect already, but then at least that has some sort of targeted (if misguided) reasoning behind it. What I can't understand, is why CPI was used to set base rates from - am I missing something (other than the state being evil)?

The bankers own the government. People like Gordon brown are there purely to act as either salesmen or lightning rods for the population.

Edited by Injin

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No, the "independent" government with Gordon Brown at the head of it was chosen by the central bankers.

The bankers own the government. People like Gordon brown are there purely to act as either salesmen or lightning rods for the population.

Either you are a very cynical man or there is an awful lot wrong in this world! :) Sadly, I think you are probably more right than wrong though.

Anyway, are there any others out there who can point out why CPI is used and why I am barking up the wrong tree?

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The only logical conclusion I can come to is that CPI was used in order to exclude house prices from the index.

CPI was allegedly to bring us in line with international comparisons, including countries where the housing market is totally different to ours.

There's nothing wrong with CPI as such. What's disastrously wrong is making it a central focus of monetary policy.

RPI is a poor measure too. If your economic instrument is interest rates, then your target should be M4 money supply.

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With all this talk of inflation/deflation, monetary vs price index inflation, I have been pondering. As our only real tool to control inflation seems to be the setting of base rates (putting aside QE), I am wondering how CPI can be controlled using this mechanism...

Hmm.

I'm not sure you can put QE fully to one side. It is not that dissimilar to open market operations, which are an established part of our central bank's toolkit.

The other main tool of course is the power of heuristics. Central bankers can change the expectations of markets just by talking, and they attempt to do so all the time. This is what Injin is getting at when he posts pictures of jawbones and stuff. When King talks about "anchoring expectations on the target", he is talking about the attempts of the central bank to simply talk inflation up or down.

http://en.wikipedia.org/wiki/Anchoring

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Some sort of tri-legged policy mechanism is needed. I think that pure inflation targetting has probably had its day as central banks have realised that they took their eyes off the ball with regards to asset price inflation.

Some sort of focus on:

Growth (preferably sustainable...)

CPI inflation

Asset Prices

Would probably be most appropriate.

Sorry I haven't really got enough time to respond properly.

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With all this talk of inflation/deflation, monetary vs price index inflation, I have been pondering.

As our only real tool to control inflation seems to be the setting of base rates (putting aside QE), I am wondering how CPI can be controlled using this mechanism. I can understand how monetary inflation can be tempered by increasing the base rate and I can understand the reverse, but CPI (and RPI) are affected by external factors too. Import prices may fluctuate due to exchange rate changes, commodity prices and so forth.

With the above in mind, how can base rates be an effective lever to control such fluctuations and may they not be counter productive? For instance, pushing up the base rate to stop CPI inflation could be counter productive - it would make credit more expensive, while import prices may be mostly unaffected. While the currency may strengthen through increased demand (for the currency), would the side effects on existing debt costs increasing not cause more problems?

Rationally, it would seem like the best way to increase demand in a currency, would be to generate industry which would increase demand for the currency. It would also seem rational for base rates to only constrain over leverage or encourage leverage depending on the state of the economy. However, using base rate changes to try to control both simultaneously (as what seems to happen when using CPI), seems to be a little strange.

Am I misunderstanding the system or is tracking an inflation index to set a base rate a throw back from a less global economy? If we were self sufficient, I can understand how CPI may be a reasonable measure (although flawed, as it seems to miss asset price inflation), but with our prices being effected as much by events beyond our control, is it still appropriate?

We have touched on some of this in another thread, but it seems like broad money (in one of its measurements) would be a better way of measuring credit expansion (ie. too much = overheating). As for attempting to shield business from external price fluctuations, would fiscal stimulus (ie. tax reductions, hand outs etc) not be the sensible action (putting aside moral hazard, whether it is wise to meddle etc)?

It looks like higher import costs may well be coming down the line, especially if our currency continues to weaken, so I would assume the existing system may well be stressed in the coming years. If we are using the wrong benchmark, the results could be disastrous. We could argue monitoring CPI has already been disastrous (HPI, then HPC etc), but maybe the worst is to come?

P.S. I'm leaving aside the points about whether there should be a central bank etc - this is meant to be purely an investigation into how the current system works and where its flaws lie.

EDIT: typo in title

I think the government really care about who is getting the newly created money, rather than how much things cost - after all they didn't try to control inflation in house prices, which is one of the few prices which affects almost the entire population. It's really all about letting some areas of the economy inflate without being included in the figures, allowing the few who control these assets to get richer.

The average man on the street accepts a pay rise based on the "cost of living", thinking that as long as his pay and investments rise by CPI every year his share of the countries wealth is kept constant. At the same time the rich are investing in sectors which aren't measured in inflation figures (e.g. housing, shares...) and hoovering up all the new money supply for themselves - using leverage with an interest rate which is unaffected by the inflation they are creating. A narrow measure of inflation that is based on the cost of basic goods, such as CPI, only acts to increase the gap between rich and poor.

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Move over Milton, listen to the King...

http://www.bankofengland.co.uk/publication...in/qb020203.pdf

(I've often wondered what the residents of Milton Keynes must think. Certainly a schizophrenic existence)

Thanks for that - very interesting read!

The conclusions are particularly interesting...

Conclusions

I return to the paradox with which I began. Most people

believe that economics is about money. Yet most

economists hold conversations in which the word

‘money’ appears hardly at all. Surprisingly, that

appears true even of central bankers. The resolution of

this apparent puzzle, is, I believe, the following. There

has been no change in the underlying theory of

inflation. Evidence of the differences in inflation

across countries, and changes in inflation over time,

reveal the intimate link between money and prices.

Economists and central bankers understand this link,

but conduct their conversations in terms of interest rates

and not the quantity of money. In large part, this is

because unpredictable shifts in the demand for

money mean that central banks choose to set interest

rates and allow the public to determine the quantity of

money which is supplied elastically at the given interest

rate.

The disappearance of money from the models used by

economists is, as I have argued, more apparent than real.

Official short-term interest rates play the leading role as

the instrument of policy, with money in the wings

off-stage. But the models retain the classical property,

that, in the long run, monetary policy, and hence money,

affect prices rather than real activity. Nevertheless,

there are real dangers in relegating money to this

behind-the-scenes role. Three dangers seem to me

particularly relevant to present circumstances. First,

there is a danger of neglecting parts of the monetary

transmission mechanism that operate through the

impact of quantities on risk and term premia of various

kinds. The current debate about the appropriate

monetary policy in Japan illustrates this point. Second,

by denying an explicit role for money there is the danger

of misleading people into thinking that there is a

permanent trade-off between inflation, on the one hand,

and output and employment, on the other. Third, by

discussing monetary policy in terms of real rather than

monetary variables, there is the danger of giving the

impression that monetary policy can be used to fine

tune short-run movements in output and employment,

and to offset each and every shock to the economy.

These dangers all derive from the habit of discussing

monetary policy in terms of a conceptual model in which

money plays only a hidden role.

Habits of speech not only reflect habits of thinking, they

influence them too. So the way in which central banks

talk about money is important. There is no

inconsistency between the consensus models we use to

analyse policy in terms of interest rates and the

proposition that monetary growth is the driving force

behind higher inflation. But it would be unfortunate if

the change in the way we talk led to the erroneous belief

that we could turn Milton Friedman on his head, and

think that ‘Inflation is always and everywhere a real

phenomenon’.

My own belief is that the absence of money in the

standard models which economists use will cause

problems in future, and that there will be profitable

developments from future research into the way in

which money affects risk premia and economic

behaviour more generally. Money, I conjecture, will

regain an important place in the conversation of

economists. As Hilaire Belloc wrote,

‘I’m tired of Love: I’m still more tired of Rhyme.

But Money gives me pleasure all the time’.

It seems funny to me that the article discusses how closely narrow money correlates to broad money, then how closely broad money matches inflation. Also funny, as the charts about growth compared to money supply, with output growth showing little change, no matter what the money supply growth is.

Why have the likes of King not been more vocal about the obvious shortcomings of monetary policy? By his own reasoning, inflation is caused by increasing the money supply and inflation doesn't spur growth. He also mentions that you can't manage fluctuations over short terms, which CPI is surely a measurement of.

Again, am I missing something? :blink:

EDIT: clarified

Edited by Traktion

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Thanks for that - very interesting read!

The conclusions are particularly interesting...

It seems funny to me that the article discusses how closely narrow money correlates to broad money, then how closely broad money matches inflation. Also funny, as the charts about growth compared to money supply, with output growth showing little change, no matter what the money supply growth is.

Why have the likes of King not been more vocal about the obvious shortcomings of monetary policy? By his own reasoning, inflation is caused by increasing the money supply and inflation doesn't spur growth. He also mentions that you can't manage fluctuations over short terms, which CPI is surely a measurement of.

Again, am I missing something? :blink:

EDIT: clarified

that there will be profitable

developments from future research into the way in

which money affects risk premia and economic

behaviour more generally.

Piggy Mervyn is too busy filling his boots to bother letting everyone else in on it.

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I thought you would enjoy that. You should at least take away from that, that it is not something they have not considered. (enough nots?)

What makes it so intriguing to me is that it was written by King himself.

Basically it is saying that they know that the volume of money causes price inflation but that it can take a long time to come through in terms of prices (because of velocity) and therefore in order to control prices, a better, more immediate instrument is interest rates that controls the take up of credit in the economy and more immediately affects economic activity and prices that way.

There is a rich vein of info waiting for you on the Bank of England website.

It seems that the price inflation takes around 5 years to be obvious after either narrow or broad money inflation. However, looking at the hyperinflation charts, the effects are much more obvious, with the prices increasing ahead of the money supply (companies expecting the worst?) and the correlation is pretty obvious within a year.

Also, looking at the Japan CPI vs broad money vs base rate, it looks like CPI mostly just bumbled along. In 89, broad money looked like it was going ballistic. Then after 91, CPI is slowly falling, yet broad money is increasing. If CPI is supposed to be some sort of early warning, would we not expect broad money start to follow it a year or so later? This doesn't seem to be the case here either. CPI doesn't seem to be much more use than tracking broad money here, as far as I can see. What's worse, is CPI will be measuring all other sorts of things, with no relevance to monetary inflation, so why is it used to control monetary expansion/contraction (via interest rates and/or QE)?

Maybe what is more telling is this passage:

Third, by

discussing monetary policy in terms of real rather than

monetary variables, there is the danger of giving the

impression that monetary policy can be used to fine

tune short-run movements in output and employment,

and to offset each and every shock to the economy.

These dangers all derive from the habit of discussing

monetary policy in terms of a conceptual model in which

money plays only a hidden role.

Maybe the problem is that such shocks cannot be tempered and it is better to just deal with the longer time frame with monetary policy. Leaving the short term tweaks, perhaps reflected in CPI or more obviously commodity prices, to fiscal tweaks. I suppose that is pretty much in line to what I first thought would be best, but it is interesting to see the figures and the reasoning why interest rates are set the way they are.

Perhaps another thought is that controlling inflation through a central bank is just too cumbersome. If they are always fighting shadows several years down the line, how can they possibly do this effectively? Perhaps this argument alone is reason enough to let supply and demand for money to dictate rates, rather than the central bank deciding from the top down?

I will have to have a look over the BoE site for some other gems! :)

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