Low inflation as a main prerequisite for dynamic and sustainable economic growth

Meeting: Monetary Policy and Economic Developement of Republic of Macedonia, November 18, 1999

Low inflation as a main prerequisite for dynamic and sustainable economic growth

First of all, please allow me to express my gratefulness to the organizer for selecting me as a keynote speaker for today's conference.

Nevertheless, there is a problem. Should I address this auditorium as Trpeski the professor, or Trpeski the Governor. Let me stress that very often, these two persons argue, enter bilious arguments, but Trpeski, the professor is much more free in his statements than Trpeski, the Governor.

Having in mind the title of the discussion: "Monetary Policy and Economic Development of the Republic of Macedonia", as well as from the theses stated in the invitation, please allow me first of all to emphasize what has been widely accepted throughout the world, and what is written in all standard university textbooks in this field, including the textbooks at the Faculty of Economics in Skopje, and that is that one should distinguish between implementation of monetary policy on short and long term.

In all standard textbooks it is stated that basic goals that the authorities want to achieve with the economic, including the monetary policy on a short run are:

·          achieving a certain rate of economic growth, i.e. achieving a certain level of output;

·          maintaining stability of the general price level;

·          maintaining the equilibrium in the balance of payments, i.e. stability of the denar exchange rate.

If the aforementioned goals are analyzed, it is obvious that some of them are of a growth character, and others are of a stabilizing character.

There is a certain incompatibility between these goals, although at first glance, there should not be any incompatibility between growth and stability of the economy. Namely, the experience (both international and domestic) shows that it is impossible to accomplish all goals to the same extent at the same time.

If an expansive monetary policy acts in direction of acceleration of the economic growth and output, such policy, at the same time, has a negative impact on the prices and balance of payments. For these reasons, the need of synchronized action on all instruments of the economic policy is more than necessary.

On a long term, there is a consensus that the monetary policy, i.e. the changes in the monetary policy influence only the prices, whereas on a short run it is possible to influence certain real variables such as output, import, export, etc.

One of the central issues in the contemporary monetary theory is the issue of the influence of monetary aggregates on economic movements. This issue is especially popular in the countries with a market economy, and therefore it is logical that it is most widely studied in those countries. In the highly developed market economies, the issue of the influence of money and credits on the economic movements is a problem that appears throughout a longer historical perspective.

Regarding this issue (but not only this one), monetary theorists in the western contemporary theory are divided mainly in two major groups. One group follows and develops the theory of Keynes and is called Keynesianism, whereas the other group follows the traditions of the quantitative theory of money and is generally called Monetarism. These are two wide and not completely homogenous groups, which involve numerous subgroups that are more compact in their attitudes.

Thus, for example, Keynesianism covers the so-called Radcliffe Committee, which is an extreme version of Keynesianism, and is mostly criticized by the Keynesianists themselves. For example, Samuelson will evaluate this movement as "the most fruitless operation of all times".

Keynesianism is nowadays dominated by two wings: one of them includes the so-called "income school" headed by Modigliani, Albert Ando, Heller and also Samuelson, although monetary problems are not his direct speciality, and the other wing, which at this moment is more superior, is headed by the Nobel prize winner James Tobin (known as "Tobin's school").

Most important and most compact in the group of monetarists is the Chicago School with its coryphaeus Milton Friedman, also including Anna Schwartz, Philip Cagan, John Klein, Richard Selden, Meiselman, Kaufman, Jordan, Anderson, etc. Among monetarists, besides the followers of the "Chicago School", special emphasis should be given to Karl Brunner and A. Meltzer, who produce the so-called "Wealth Adjustment" theory, but of course, one must not forget Patinkin, Mayer, Fand, etc.

The Chicago School produced the so-called reformulated quantitative theory of money, which is today becoming more and more popular throughout the world, and which has an increasing influence on the conduct of monetary policy in numerous countries with a market economy. By this theory, money is the leading factor in the influence on the economic movements. The incurring changes derive from the changes in money against the changes in the economic movements. Money demand is the key determinant, which is a stable function, whereas the influence is expressed in the process of adjustment of the real quantity of money to the demand, i.e. in the process of reestablishing monetary balance.

The influence of money on the economic movements is evident after a certain period of time which is uneven and depends on series of factors influencing the processes of reestablishing balance between the permanent quantity of money and the money demand. Since this time lag can not be determined with a high level of certainty, according to Friedman it is logical that most efficient monetary policy will be conducted with money growth rate being constant. Stating this, he actually denies that a successful stabilization policy can be conducted by having a discretionary monetary policy.

The increasing popularity of this theory is a result of its sound empirical foundation. Abundantly using the latest achievements in statistics and econometrics, the followers of quantitative theory proudly emphasize that they do not claim that Keynes' theory is incorrect, but that their empirical research shows that there is a firm link between monetary and real aggregates.

Other competitive western theories are not empirically tested and verified. Those are basically the neokeynesian theories, such as the Portfolio Balance theory of James Tobin. It is actually a wealth choice. The individual or the community allocates its savings among alternative wealth. According to the Portfolio Balance theory, money is only one type of wealth, being not higher appreciated compared to the other types of wealth. Changes in the economy may occur if the relative wealth structure is changed, initiated by any type of wealth.

However, according to the Wealth Adjustment theory of Brunner and Meltzer, money should not be equalized with the other types of wealth because money is a "special type of wealth". Actually, Brunner and Meltzer claim that, differences between money and other wealth are much more noticeable than in theory and it does not take much effort to prove that the changes in the quantity of money are far more closely related to the economic activity than any other type of wealth. However, unlike Friedman, other followers of the Chicago School Brunner and Meltzer do not have firm attitudes that only changes in the money supply influence the economic activity, but according to them, changes in the money supply are a dominant factor, however not the only one. One of the largest problems regarding the influence of monetary aggregates on the economic movements is through which transmission mechanism these effects are transferred.

According to the Reformulated Quantitative Theory, changes in money result in direct changes in income and prices. According to Keynes' Liquidity Preference Theory, changes in the money supply result in changes in the interest rate and in the profit rate of capital, so in that sense, changes in the money supply can directly influence economic movements.

In Tobin's Portfolio Balance Theory, changes in the money supply or changes in any other type of wealth result in changes in the structure of interest rates. According to this theory, the transmission mechanism is as follows: changes in money (or any other type of wealth) - changes in interest rates (not one, but all interest rates) - changes in the demand for capital - changes in the economic activity. There are differences also in the understanding of the direction of effects. Both the Quantitative Theory and the Liquidity Preference Theory affect the economic activity in same direction by changing the quantity of money. According to the Portfolio Balance Theory it is possible, however it does not have to be the case - even the direction may be opposite.

However, contrary to the academic circles that are free to enter endless arguments, policy-makers do not have that freedom, they have to make decisions.

In the 1960s, especially after Phillips curve appeared, there was an opinion that by conducting more liberal monetary policy, i.e. by allowing certain growth in prices, it is possible to act in direction of decreasing unemployment on a short term.

However, popularity of Phillips curve was very short, because in 1970s the world faced with another phenomenon - coexistence of high inflation and high unemployment.

Since that time, it has been widely believed that the effects from the higher inflation on the increase in employment (which occurs through the decrease in real wages) are very small and they quickly disappear, by including the mechanism of inflatory expectations, which the economic entities implement in all their decisions. In that way, the positive effect on growth disappears, and the unemployment rate returns to the initial level. The only thing that remains is the higher level of inflation. This has been proved in many countries throughout many years, and has been supported by a large number of empirical studies.

In other words, in the 1960s the belief that on a long term there is no positive relation between inflation and employment, and that on a short term there is a certain relation between the increase in inflation and employment, prevailed. Since 1970s, and especially in the past 10 years, the consensus that on a long term there is no positive relation between inflation and employment remains, whereas regarding the relations on a short term, the opinion about the positive relation between the inflation and employment has completely changed, and now the prevailing opinion is that the damages from the inflation on a short term are so much bigger than the possible short benefits, so that the monetary policy should not have any other objectives - except achieving low inflation.

Most of the countries (highly developed) have implemented this in their central bank acts - that their concern is to maintain low inflation.

The question that raises is - how low inflation?

Alan Greenspan says: "Inflation should be so low that the economic entities would not take it into consideration when making economic decisions".

It means that price stability is achieved at the moment when economic entities would not incorporate inflatory expectations in their decisions.

Does that mean that monetary policy should have zero inflation for its target?

In highly developed countries, where the ultimate goal of the monetary policy is inflation - almost in all of them, an incorporated goal of the monetary policy which should be accomplished by monetary policy and other instruments of economic policy is an inflation of 2%.

The question that raises is - why not zero?

Zero inflation is not advisable because prices of goods may increase by 1% to 2% due to their improved quality, and it should not be destimulated.

Also, in these 20 developed industrial countries, there is a widely accepted opinion that the central bank should intervene if the inflation increases by one percentage point above the 2% target, or if it decreases by 1 percentage point, and if it is estimated that there is a tendency that increase or decrease to continue.

For the countries in transition somewhat higher rates are tolerated, but however they are within the zone of a single digit inflation. As a matter of factly, all empirical studies point to the negative influence of inflation above 10% on employment and growth. There are no empirical studies about the negative influence of the single digit inflation on employment and growth.

Also, the opinion that prevails nowadays is that the policy of low inflation is the main precondition or sine qua non for a stable and high growth and favorable developments in employment. Therefore, separate discussions in our country regarding higher inflation as a remedy for solving certain economic problems, has been long considered an anachronism in the world.

If a low inflation is maintained for a longer period of time, it inevitably leads to a decline in interest rates, and lower interest rates have a positive influence on economic growth and increase of employment.

Low and predictable inflation on a longer term acts in direction of inflow of foreign direct investment, which also, especially in countries in transition, has an influence on increase in growth.

However, the challenge to use monetary policy in order to stimulate employment still exists. There is such danger even in developed countries, especially before elections or during elections.

For these reasons, in order not to misuse the monetary policy, in all countries (highly developed) laws were enacted or amended to provide high level of independence of central banks.

Independence is expressed at two levels:

1.       Independence with respect to the executive authority.

2.       Independence with respect to the Parliament.

Almost all central banks in the highly developed countries are independent with respect to the executive authority.

A smaller number of central banks (such as Bundesbank, Central Bank of Switzerland, USA, New Zealand) are independent with respect to the Parliament, too.

What does this mean? That means that they independently determine the tasks and objectives of the monetary policy regardless of what the intentions of the Government and of the Parliament are.in that respect, a significant progress was made by the establishment of the European Central Bank within the framework of the European Monetary Union.

The European Central Bank is a fully independent institution, both in formulating the targets of the monetary policy and in their realization.

In addition, the European Union took a step forward. It urges the countries attempting to enter the European Union to change their legislation, and the status of their central banks to be equalized with the status of the European Central Bank.

Currently, Slovenia is in negotiations with the European Union. One of the requirements is that the Bank of Slovenia Act to be amended and the status of the Bank of Slovenia to be equalized with the status of the European Central Bank.

Another thing on which the European Union insists is that the countries attempting to enter the European Union should implement provisions in their central bank acts stipulating that their main task is to maintain low inflation rate.

Third thing on which they insist is to pass a law with which the Central Bank is prohibited from financing the deficit in the Budget.

The issue of determining the goal of the monetary policy and its quantification is really very complex, and I think that one should approach with a long-term vision. In my opinion, the Republic of Macedonia should cease determining annual inflation targets, and start determining mid-term inflation target instead, which could be defined as maintaining the inflation rate within the interval 4%-5% in the period up to 2005. Why is it necessary to adjust the time horizon when projecting the inflation from short to medium term? There are several reasons:

1)      Monetary policy and its goals do not simply end up on December 31 and they do not start on January 1 each year. Monetary policy conduct is a continuous process with clear goals, and they should be determined in advance in order to achieve maximum transparency and disclosure for the economic entities about the long-term vision of the macroeconomic and monetary policy;

2)      Correction of relative prices in the Republic of Macedonia has only started, but is has not been finished yet. It is a process that requires sufficient time: first, to neutralize the inherited distortions; and second, to incorporate standard and continuous processes of adjustment of relative prices, which reflect the changes of productivity and costs of operations in the domestic and foreign economies;

3)      The long-term inflation target would be consistent with our strategy for entering EU and EMU. Tighter pegging of our currency to the EURO implies creation of conditions for maintaining the inflation at a low level, but also a significant reduction of interest rates;

4)      Monetary policy is actually a combination of ex ante inflation target and discretionary reply to certain shocks. By the long-term target, more space would be given for larger flexibility in defining the short-term projections, without losing the clear long-term goal. This would enable to incorporate the information about possible shocks which could hit the economy in the short-term projections, except those that acting purely on the supply side. Having a long-term inflation target, monetary policy will be in position to decide whether to react to those shocks on a short term, or it will estimate that conducting counter-cyclical monetary policy is economically irrational and expensive.

A potential problem with the long-term inflation target could be the possibility that the short-term results will deviate from the long-term objective, with a risky impact on the credibility of the Central Bank. However, the long-term inflation target will have to incorporate the expectations of the economic entities on a long term, and the National Bank should have a positive influence on building those expectations.

If price stability is the best contribution that the monetary policy can give to the economic growth, a question raises - how and by which concept to achieve this? In general, successful monetary strategies have two common characteristics: they are long-term oriented and they provide a transparent standard for policy evaluation. With that respect, central banks use various goals, which express the dedication of monetary authorities to maintaining price stability in the most convincing way. Therefore, with variable success in various countries, three strategies are used: monetary aggregates targeting, direct inflation targeting and exchange rate targeting.

The strategy of monetary aggregates targeting, which was dominant in the Republic of Macedonia until 1995, is not a good solution for the country's current stage of development. Out of 27 transition countries, 12 have implemented this strategy, but none of them belongs to the group of 10 most successful economies in transition. Of the developed countries, this strategy was most successfully and most permanently applied in Germany and in certain form in Switzerland. After Germany entered the EMU, the Bundesbank strategy was only partially transferred in the monetary policy of the ECB, which uses a sort of combination of the monetary strategy targeting and direct inflation targeting.

The second alternative is direct inflation targeting, which as a strategy has been applied by approximately ten developed countries, but recently it has been widely popular with some pilot countries from Central Europe (primarily Czech Republic and Poland). The initial results from this recent monetary strategy are positive, having transparency, relative flexibility and avoiding the problem of estimation of the velocity of money, as main attributes of this strategy. However, this concept has a basic weakness: direct control of the inflation can not be achieved by monetary policy. Having in mind that it can easily cause initiate repressed inflatory expectations, this strategy for the Republic of Macedonia also remains in the zone of future solutions.

The current strategy of monetary policy in the Republic of Macedonia, exchange rate targeting, has been applied in half of the countries in transition: in four countries in the most rigid form of a currency board and in nine countries in the form of pegging the exchange rate to one or a basket of several world currencies. In five of these countries there is a regime of fix central parity of the exchange rate with bands between +- 2.25% (in Hungary) and +- 7% (Poland and Slovakia). The advantage of this strategy is in the transparency of the exchange rate signals sent to all economic entities. With strict application of this strategy, in the Republic of Macedonia, monetary, fiscal and wage policy were successfully disciplined, which enabled the inflation to be reduced at a low and stable level.

However, just as any other strategy, this one also has its disadvantages, which are obvious especially when it is applied for a long time. Thus, the basic disadvantage of this strategy is that pegging to a fixed parity with relation to the currency of another country means losing the autonomy of the monetary policy and impossibility to amortize certain domestic shocks, or shocks transferred from the anchor country. In the past years, a serious problem were the difficulties to amortize certain shocks through the monetary policy, at least those that acted on the demand side, which together with the shocks on the supply side were abundant throughout the past years. Consequently, the positive effects from the application of this strategy were gradually exhausted, and the potential weaknesses become more and more apparent. In other words, the burden of maintaining the fix parity in conditions of structural problems, unused capacities and other economic rigidities, is born by the monetary policy. Throughout the past years, fiscal policy has provided adequate support for the monetary policy, and the policy of wage restriction has also acted in that direction. However, the room for maneuver of the monetary policy is much too small, which is especially apparent in conditions of global shortage of foreign currency (as it was the case during the war in SRY), or permanent high inflow of foreign currency (as it was the case in the past four months). In both cases, pressures on the foreign exchange market are transmitted to the money market, causing high interest rates oscillations.

What will be the optimum solution for the Republic of Macedonia, in the next several years? According to all positive and negative arguments, the most efficient way to maintain price stability is to maintain the fix central parity of the Denar against the EURO. The elaborated reasons indicate that a certain dose of flexibility is needed in this set-up of the exchange rate regime, which will be provided by allowing oscillations of the exchange rate around the central parity within certain bands. On the basis of the rule for uncovered interest parities, bands could be 5% above and below the central parity, which is somewhat below the level of interest rate disparities between the Republic of Macedonia and Germany, as an anchor country. In this way, the control over the inflation rate and inflatory expectations will be maintained, and the monetary policy will be given more room to amortize the shocks in the domestic economy, which are on the demand side.

However, one must not forget that the exchange rate regime and the exchange rate are not a supplement for the structural reforms. Monetary policy can not take the economy where we all want. The money supply growth can only facilitate or support the economic growth. The problems of the long term development of Macedonian economy lie in structural rigidities, limited resources, inefficient allocation of assets and in all other incomplete processes of micro and macro restructuring. It involves conduct of responsible and consistent long-term policy, in which the concept of price stability would not be abandoned, but understood only as stability and not unchangeableness. This may from time to time make central bankers unpopular among the public, which is within the scope of their operations. The strive to give the monetary policy another role - will only draw the attention off the real problems.

Finally, let me conclude:

Nevertheless, we better be modest when evaluating what we believe we know today.

Summers in his work: Why central banks should implement low inflation on a long run has stated: "It will be a wrong reading of history to think that we have discovered the ultimate truth and that some of the opinions here will not look obsolete in 20 years".

This is an incurring and challenging statement. Just think how boring life will be if we discover the ultimate truth.

  
Ljube Trpeski
Governor