Should the central bank aim for zero inflation?

When we read commentaries in the media regarding the state of the economy, we get the impression that inflation is the number one problem. Would we all be happy if the central bank took the necessary steps to reduce inflation close to zero?

How much inflation should a central bank be willing to tolerate?

I.

Admittedly ,inflation imposes the following costs on people! Those with fixed incomes such as pensioners suffer most, such people are usually the elderly unable to find employment to supplement their pensions with wages.

II.

If you lend a thousand dollars to someone this year and inflation rages on by the time the borrower repays the loan it has lost a good deal of its purchasing power.

III.

Inflation brings about confusion and inconvenience in business transactions. It is difficult to budget for a reasonable time when you are not sure what you will be paying for the spares or raw materials you are going to buy.

IV.

Inflation aggravates income inequality; often the rich become richer while the poor become poorer.

Because of these reasons some economists feel that a central bank should adopt as primary policy reducing inflation at least next to zero, other economists go so far as to suggest that Parliament should enact a law that keeping prices low should be mandatory on government.

Incidentally, what they call inflation in developed countries would not worry most people in developing countries. An annual increase in prices of 3 percent is seen as highly inflationary. Here in Malawi inflation has for at least two years been in double digits.

Combating can be costly. What a bank does is to raise interest rates in order to squeeze credit and reduce the flow of money in the economy. But when it does so, firms stop borrowing working capital from the commercial banks; they stop expanding production. This trend could lead to a recession which in turn means growing unemployment.

Those who say that a central bank should aim at reducing inflation to zero or near zero point out that the costs of disinflation are temporary, while the benefits are more permanent. They exhort to accept short -term unemployment for the perceived long-term benefit.

These people cite an example from recent United States economic history. In early 1980s Paul Velcker, the chairman of the Federal Reserve system of the United States tightened monetary policy and reduced inflation from about 10 percent in 1980 to about 4 percent in 1983. Though in 1982 unemployment reached its highest level since the Great Depression of the 1930s the economy eventually recovered from the recession. The recession had cost President Jimmy Carter a second term as the Ronald Reagan adminitration over a healthy economy, a result of Paul Velcker’s monetary policy.

Those deposed to zero inflation policy feel that moderate inflation plus lower unemployment is better than zero inflation with high unemployment. Unemployed people suffer social and income trauma. Being unemployed they lose self-respect; being unemployed means lower incomes.

When people are unemployed, they lose the skills and experience they gained while they were employed. Some of them are too advanced in age to benefit from retraining for jobs that might occur later when the economy revives.

It is noteworthy that in developed countries both interest and inflation rates are very low to compare to what they are in developing countries. At the same time, we notice that in developed countries annual growth rates of the gross domestic product (GDP) seldom shot up to 3 percent, indeed some of these seldom go up to 1.5 percent either.

These rates appear satisfactory because demographic growth rates are low. In developing countries where population grew annually by two and a half to 3 percent the GDP has to be above five percent for the people to experience higher standards of living.

If a central bank’s monetary policy is to affect standards of living positively it must be part and parcel of an economic and social policy. There must be effective policies against excessive population growth rates.

Political leaders shy away from advocating slow population growth rates. I remember decades ago reading the autobiography of Sir Julian Huxley, a grandson of Thomas Huxley,a the friend and admirer of Charles Darwin. In that biography Sir Julian wrote that on his visit to Malawi he had appealed to Dr. H.K. Banda to launch a population control policy and that our first president rejected the suggestion.

The above discussion should remind us that the questions of prices such as these of statutory corporation and food are complex. These low food prices discourage farmers, too high prices hurt consumers. Any appeal one makes should be based on advice.