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Price Stability for Sustainable Economic Growth

Asset price distortions usually appear in an environment where individuals and businesses are not sure where prices — of both assets and credit — are heading and fail to effectively and productively plan ahead.

Increased price distortion raises uncertainty about the outcome of business decisions and profitability, imposes negative effects on the cost of investment, reduced effectiveness of the price and market systems, and in particular, gives birth to distortions that create perverse incentives to engage in nonproductive activities.

The later is the most important. Non-productive activity induced by distortion of price incentives results in overinvestment of resources — for example the overinvestment in real estate across the world, including the UAE, in the last several years.

Flow of money into the real estate sector is considered business as usual as long as people are buying homes to live in.

But if people are buying homes as investments, and a lot of them are doing that, it means there is some sort of price distortion — low real interest rates, low returns or at least the perception of it from usual investment instruments like stocks and bonds etc.

The problem is that the costs of such overinvestment decrease the resource base available for growth in other sectors in the economy — that hurts when the overinvested sector or asset tanks and no other sector has the strength to hold the economy.

Central Banks usually intervene as soon as they see the onset of a bubble in the economy.

A delayed response, a sudden removal of the distortionary incentive, leads to a rapid transfer of resources out of that sector, causing unemployment and business failures.

Some would argue that establishing price stability as the primary goal of monetary policy means that central banks will no longer be concerned about output or growth.

However, the argument skips the fact that a stable price and financial environment almost certainly will enhance the capacity of monetary policy to fight occasions of cyclical weakness in the economy.

Over the long run, price stability will be the one sustainable contribution monetary policy can make to economic growth. While central bankers may differ in the ways they seek to achieve price stability, the goal is the same — to minimise the economic costs inflicted by price uncertainty on the economy.

Price stability is not just about keeping prices low, but to keep inflation expectations anchored over the longer term by some transparent commitment by the Central Bank to an articulated standard – usually a declared target range.

Unavoidable deviations from the longer term goal of price stability, like a supply shock, may then be explained with reference to that standard.

For these purposes, a consistent measure of price stability is more important than what that exact number is.

· ovais@khaleejtimes.com