Dynamic concept Fiscal policy Inflation and yield

An inflation control system

As a control engineer, I have been learning and researching economic phenomenon from process control perspectives. One of my favorite areas of interest is inflation control.

Maintaining inflation within certain target is one of the most important mandates for almost all central banks in the world. As a matter of fact, it is the sole mandate for the U. S. Fed when in creation. The U. S. Fed late added maximizing employment as a second mandate. However, operationally inflation control is the most direct goal for the Fed when forming monetary policies. Inflation, via monetary transmission mechanisms, influences economic growth and hence employment changes. Inflation control system is a feedback control system and it can be described as following:

– The controlled parameter is inflation. Total inflation is the target to control, however the total inflation is subject to fluctuations due to items that are sensitive in prices. Operationally such instability can cause difficulties in forming control strategies. Therefore the central banks typically use so called core inflation as an operational target. The core inflation excludes items of volatile prices such as food and gasoline.

– feed back is the measures (reading) of inflation, a familiar item is consumer price index (CPI). The CPI is reported monthly in terms of increase/decrease month over month and year over year.

– set-point is the target of inflation which is typically core inflation such as CPI. The number of set-points are varied among different countries, dependent on macroeconomic policies at specific country. The U. S. Fed uses 2% as its target. The Bank of Canada adopts a range of 1 – 3% centered at 2%. The Bank of Japan had used 1% but was relaxed to 2% since early this year. The European Central Bank pursues a target of 2% or less.

– control strategies are monetary policies, some time can also include government fiscal plans. A conventional monetary policy is the federal fund rate which the central banks use to influence money market rates and long term interest rates. The Central banks conduct monetary policies based the deviation of inflation from its target. Conventionally, if the inflation is lower (higher) than its target, then the monetary policies will be eased (tightened) such as cutting (increasing) federal fund rate.

The inflation control system is a very complex system. First the set-point is difficult to choose. The choice of set-point often reflects a nation’s macro economic focus and they are also affected by culture and sometimes political wills. They can be categorized into following:

– growth set-point. These countries includes emerging markets, where the set-point is high (in the middle single digit). Inflation is often used to propel fast economic growth.

– set-point at mature economies. These countries include advanced economies where they pursue more stable and sustainable growth. Inflation target is often at low single digit. They can further divided into three subcategories.

– set point method. The U. S. Fed uses 2% as it’s target, and The Bank of Japan used 1%.

– symmetric range method. The Bank of Canada uses a range of 1 – 3% with center at 2%.

– asymmetric range method. The European Central Bank uses 2% or less.

The inflation target can be adjusted according to the need to meet economic development, but at risk of the Central Bank’s creditability. The Bank of Japan had adopted an inflation target of 1%. I think the target had been too low and it was partially responsible for the stagnation of the Japanese economy since 1990. I predicted that the Bank of Japan would move up the target to 2% in a note in January 2013 and several months after that the Bank of Japan, at the interference from the new prime minister, indeed changed the inflation target to 2%, paving the way for the ultra loose monetary polices in Japan in the following months. For the U. S. Fed, I made a similar prediction to relax the inflation target from 2% to 3%. The Fed actually relaxed tolerance to 2.5% since middle of this year.

The second complexity in the inflation control system is the large delay in taking effect on the economy once new policies are applied. For example, the impact of monetary polices on real economies could take several quarters and even several years. There are three ways for the central bank to tackle large delays in the inflation control system. First is to base on expert judgement of future impact and this is also enhanced by analysis and results from computer models. Second is to manage public’s expectation of future policies and economic outlook. These two strategies are built into monetary policies as feed forward control term. Thirdly, when necessary, to adopt direct control such as large scale asset purchases where it take much less time to take effect in the real economy than the conventional monetary policy tools. Fiscal policies such as reducing taxes is also a direct control method.

The third complexity is that the inflation control system is under a context of a more complex economic control system where multiple goals have to be achieved using multiple control inputs. These goals are often coupled and sometimes are even conflicted with other.

There are other aspects of complexities with inflation control and my note lists only three of them. Despite these difficulties, the central banks are now in a much better position to control the inflation than twenty years ago. First economy theories have provided better understanding of the dynamics of the economic system. Second, we have better and more accurate measurements of economic indicators, and thanks to the information technology, these data come with minimum time delays. Third, the central banks have equipped with more tools for monetary policy purposes. In that sense, I have much less worry of inflation this time although the central banks around the world are entertaining loose monetary policies. I am sure they all have the wisdom and tools to make inflation under control. That was my very reason predicting crash of gold prices this year.

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