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Inflation and the Credibility of Central Banks

Friday, 06 August 2010 04:51

The WSJ had a piece on the European Central Bank's (ECB) decision to buy a small amount of government bonds. It raises the question of whether this could jeopardize the ECB's credibility as an inflation fighter.

This is an interesting question. According to central bank folklore, credibility as an inflation fighter comes from being willing to impose a severe recession to squeeze inflation out of the system. Paul Volcker sits at the top in the Central Banker's Hall of Fame for his willingness to keep interest rates high through 1981-82 recession. The folklore tells us that we don't  want to lose this hard-earned credibility by allowing inflation to rise now.

It is worth noting that in its length and depth, the 1981-82 recession is being dwarfed by the current downturn. In other words, even if aggressive monetary expansion did lead to inflation that central banks subsequently felt necessary to rein in, the cost in terms of unemployment and lost output is likely to be less than we are now experiencing.

This should make more expansionary policy at present a no-brainer, but we have to remember, our central banks are run by people who could not see an $8 trillion housing bubble.


Comments (2)Add Comment
written by izzatzo, August 06, 2010 7:16
Pyschologists have proven that inflation phobia is a legitimate, diagnosable mental disorder on the same level as other disorders such as fear of heights or fear of flying. Specifically, it's not rational because it has no corresponding fear from the other extreme, i.e., no fear of the ground or no fear of driving, demonstrated by clear oblivion to any fear of deflation.

In a controlled experiment, some inflaphobes were exposed to declining prices in a Dutch auction, where announced prices are lowered until a buyer takes the price, and the inflaphobes didn't flinch. But in an auction where prices were bidded up by potential buyers, they all fainted on the spot.
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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.