May 23, 2017

Economic Scene: Making the Case for a Rise in Inflation

So I understand Paul Volcker’s impatience with those tempted to let inflation rip — at least a little bit — to spur economic growth.

“The implicit assumption behind that siren call must be that the inflation rate can be manipulated to reach economic objectives — up today, maybe a little more tomorrow, and then pulled back on command,” Mr. Volcker said in a speech at the Economic Club of New York a few weeks ago. “All experience amply demonstrates that inflation, when fairly and deliberately started, is hard to control and reverse.”

And yet despite Mr. Volcker’s enormous skepticism about the merits of inflation, a heretical thought that first surfaced as the economic crisis gripped the world five years ago is again gaining traction among experts: economic policy should be aiming for significantly higher inflation than the 1 to 2 percent annual rate that the United States economy is currently experiencing.

When Mr. Volcker took the helm of the Federal Reserve in 1979, inflation neared 12 percent — a catastrophe by American standards. He spent much of his eight-year tenure strangling the economy with high interest rates. By 1983 the unemployment rate surpassed 10 percent — a feat not replicated even in the latest recession. He was reviled by home builders and auto dealers, whose businesses depend on credit. Prominent members of Congress asked him to resign.

Mr. Volcker ultimately won his battle. In 1986 he brought inflation below 2 percent. That’s the pace that has since become the de facto definition of “price stability,” a target for central banks around the world. Among economic policy types, he is considered a hero.

But now mainstream economists like Kenneth Rogoff at Harvard are pressing the case that “a sustained burst of moderate inflation is not something to worry about.”

“On the contrary,” he wrote, “in most regions, it should be embraced.”

The prescription fits the worldview of some “monetarist” economists, who argue that the Fed should set a higher target for the nominal gross domestic product, to be met through real economic growth and inflation. Conservative pundits like Josh Barro of Business Insider have welcomed inflation as the right’s answer to fiscal stimulus — a way to juice the economy without increasing government spending.

But it is hardly a conservative idea. Paul Krugman, a Nobel laureate and liberal columnist for The New York Times, has been writing about the benefits of higher inflation, arguing that policy makers should be using any available tool — fiscal or monetary — to try to reduce an unemployment rate stubbornly stuck at more than 7.5 percent for over four years.

To be sure, economists agree that inflation is no panacea. Higher inflation does not produce more growth or lower unemployment over the long term. There is a fairly solid consensus that unstable, volatile prices depress growth by short-circuiting decisions to spend and invest. That is why central bankers work so hard to “anchor” inflation expectations to a number.

But economists have also come to understand that an economy can suffer from too little inflation as well. Janet Yellen, the Fed’s current vice chairwoman, convinced Alan Greenspan more than 15 years ago, when she was serving an earlier term on the Fed, that setting zero inflation as a target was a bad idea that would complicate the necessary adjustment of relative prices in the economy.

The experience of the Great Recession over the last five years has persuaded many economists, among them Olivier Blanchard, the chief economist at the International Monetary Fund, that a higher inflation target in good times would allow central banks to do more to fix things when the economy went bad.

With inflation anchored at 2 percent, real interest rates could fall no further than a negative 2 percent, hitting a floor when the nominal interest rate reached zero. If it had been anchored at 4 percent, real rates would have had further to go, providing a more robust boost to investment and spending.

These arguments apply to steady-state inflation in normal times. But with the economy still mired in the mud, and the odds of more fiscal stimulus near zero, economists like Mr. Rogoff and Gregory Mankiw of Harvard want to give the monetary screw another turn and have called on the Fed to engineer higher inflation now, aiming for maybe 4 percent or even 6 percent.

One main feature of inflation is that it reduces the real value of debt. Think of the $13 trillion in outstanding mortgages or the $12 trillion in government debt held by the public. Inflation would eat away at those obligations, without any need for bankruptcy lawyers. And it would leave more disposable income for Americans to spend.

Higher inflation in the United States would also weaken the dollar, helping exports. It would encourage people to spend now rather than sit on their cash.

And if the government engineered “monetary repression” to keep long-term interest rates below the economy’s nominal growth rate, effectively forcing banks to buy lots of government bonds, a few years’ worth of higher inflation could do wonders to reduce the public debt.

Mr. Rogoff points out that the case for higher inflation was stronger in 2008, when mortgage debt reached $14.5 trillion and debt service swallowed almost a fifth of households’ disposable income. Still, he notes, a solid case remains for faster-rising prices around the world.

Higher inflation in Germany, Europe’s juggernaut, would make it easier for the damaged economies that share the euro — like Greece, Portugal and Spain — to reduce their relative labor costs and increase their relative competitiveness.

Japan is finally giving higher prices a shot. In April, the new central bank governor, Haruhiko Kuroda, announced that he would pump huge amounts of yen into the economy to try to shake nearly two decades of stagnant, even falling, prices and raise inflation to 2 percent. While this would count as price stability by American standards, in Japan it amounts almost to runaway inflation. 

Yet for all the merits of the argument, the chances of the policy’s being more widely adopted are close to nil.

There is resistance from more than Mr. Volcker. Jeremy Stein, on the board of the Fed, has taken to worrying that the central bank’s loose monetary policy is already imperiling the financial system, stoking future bubbles as banks load up on risky assets to achieve their profit targets. Mark Gertler at New York University worries that long-term interest rates would simply follow inflation up — negating much of its benefit.

The Fed chairman, Ben Bernanke, told Congress last month that the central bank might soon move in the opposite direction, tightening monetary policy by cutting back on its program of bond purchases, which today total $85 billion a month.

And here’s the best reason to be skeptical: even if the Fed wanted to engineer higher prices, it is far from obvious how it would do that.

The Fed is not just buying bonds. It is also keeping short-term interest rates at zero. And it promised to keep pushing the economy at least until the unemployment rate fell below 6.5 percent or inflation surpassed 2.5 percent.

And yet, inflation is going the other way. The economy is even flirting with deflation. The bigger risk in the United States is not that our money will buy fewer oranges tomorrow. It’s that it will buy more.

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