Central banks, when targeting, should start by making sure they are targeting the correct target; and the last thing they should do, is to promote distortions in the allocation of bank credit.

Sir, Marie Owens Thomsen writes: “Today, governments tend to run only budget deficits, making them rather structural. This leads to ever-rising debt levels and poses a potential policy dilemma. Thanks to the blissfully low rate of inflation, it is possible to ignore this fact. But should inflation hypothetically shoot up, it would quickly become apparent. Central banks could find themselves unable to raise policy rates enough to combat price increases without causing a debt sustainability crisis at home.” “Central banks need to be less dogmatic on inflation targeting” May 8.

Scary stuff, but even more so when one considers the following:

First, that the targeting of inflation is based on an entirely subjective measure of inflation. Just as an example it is based on the cost of renting houses but not the price of houses.

Then second, the artificially imposed risk weighted bank capital requirements, which among other much favor “safe” sovereign debt over “risky” loans to entrepreneurs and SMEs, is distorting the allocation of bank credit to the real economy, and sends out the wrong interest rate signals. For instance had the EU authorities not assigned a 0% risk weight to all Eurozone sovereigns, even though these were getting indebted in a currency that de facto is not their domestic (printable) one, Greece would never have been able to build up the exposures to German and French banks that doomed it to a crisis.

@PerKurowski

If the inflation-measured basket used house prices instead of rental costs, the story would be different.

Sir, Rana Foroohar points to “The latest Consumer Price Index figures show that almost all core inflation… was in rent or the owner’s equivalent of rent (up 0.3 per cent) [while] Core goods inflation, meanwhile, was down 0.2 per cent” and argues “that the housing market is once again completely out of sync with the rest of the economy.” “America’s new housing bubble” March 18.

Yes and no! No! “Rent” in much is a laggard response to the price of houses, and so it would be more precise for the arguments made by Foroohar to compare core goods inflation to what is happening to those prices.

Yes! “Hyman Minsky would have had a field day [more precisely many field years] with his Financial Instability Hypothesis that [argues] two kinds of prices — prices for goods and services, and asset prices.”

And yes, Daniel Alpert is correct: “What we have now is a form of inflation that’s never been seen before — it’s all concentrated in housing.”

To explain that with as “something the US Federal Reserve has actually exacerbated (albeit unintentionally) via low interest rates and quantitative easing that boosted housing prices in the very cities where the best paying jobs are located”, is correct but quite incomplete.

If banks needed to hold as much capital against residential mortgages as against for instance loans to entrepreneurs, something that was the case before the Basel Committee got creative, that would be happening much less.

As is, the resulting abundant easy financing when purchasing a house has helped morph houses from being homes into being investment assets. 

PS. In a letter I wrote and that FT published in 2006 (before it stopped doing so) titled “The information Mr Market receives could also be neurotic” I argued:

“Inflation as they, our monetary authorities, know it, is just obtained by looking at a basket of limited consumer goods chosen by bureaucrats and that although they might be highly relevant to the many have-nots, are highly irrelevant to measure the real loss of value of money. 

For instance, who on earth has decided for that the increase in the price of houses is not inflation? And so what should perhaps be argued is that really our monetary authorities have not been so successful fighting inflation as they claim they have been.”

@PerKurowski