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The Dangerous Delusion of Price Stability

Since the high inflation of the 1970s, which central banks were right to combat by whatever means necessary, maintaining positive but low inflation has become a monetary-policy obsession. But, because the world economy has changed dramatically since then, central bankers have started to miss the monetary-policy forest for the trees.

BASEL – The major central banks’ vigilant pursuit of positive but low inflation has become a dangerous delusion. It is dangerous because the policies needed to achieve the objective could have unwanted side effects; and it is a delusion because there is currently no good reason to be pursuing the objective in the first place.

In the 1970s, when inflation in the advanced economies rose sharply, central banks rightly resisted it. The lesson central bankers took from that battle was that low inflation is a necessary condition for sustained growth. But, subtly and over time, this lesson has morphed into a belief that low inflation is also a sufficient condition for sustained growth.

That change may have been due to the benign economic conditions that accompanied the period of disinflation from the late 1980s to 2007, commonly referred to as the “Great Moderation.” For central bankers, it was comforting to believe that they had reduced inflation by controlling demand, and that their policies had many beneficial side effects for the economy. After all, this was the demand-oriented narrative they had used to justify tight money to begin with.

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