For inflation to work, a central bank must have key market participants believe they will inflate, while having the masses believe the prices will remain about the same as recent past. The moment the majority of the public believes that prices will move higher over the longer term, they will bid general prices significantly higher. This will cause the central bank to tighten monetary policy and push the economy into a recession.
To prevent price spikes, the central bank must keep most participants guessing. To see through all the central bank double talk, the following rule should be used when analyzing future central bank decisions: The central bank must ensure money supply is increasing. The only exception to this rule: Except when money supply contracts.
The exception to the rule may sound odd at first, but a contracting money supply usually follows a boom. The banks themselves are likely to be in financial trouble at this point in the cycle, which is why the money supply is contracting. The central bank could step in to increase the money supply, but it is very difficult for a central bank to increase the money supply (i.e. Q.E.) when the boom is in progress. Not only would a Q.E. program be politically difficult, but market participants would bid prices much higher. So a central bank must wait for the bust to surface to provide cover for future money supply growth. Then the first rule takes effect and the business cycle unfolds.
To prevent price spikes, the central bank must keep most participants guessing. To see through all the central bank double talk, the following rule should be used when analyzing future central bank decisions: The central bank must ensure money supply is increasing. The only exception to this rule: Except when money supply contracts.
The exception to the rule may sound odd at first, but a contracting money supply usually follows a boom. The banks themselves are likely to be in financial trouble at this point in the cycle, which is why the money supply is contracting. The central bank could step in to increase the money supply, but it is very difficult for a central bank to increase the money supply (i.e. Q.E.) when the boom is in progress. Not only would a Q.E. program be politically difficult, but market participants would bid prices much higher. So a central bank must wait for the bust to surface to provide cover for future money supply growth. Then the first rule takes effect and the business cycle unfolds.
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