The pros and cons of inflation
The Fed aims to keep it low and slow, but the economy still isn't cooking
By Kristin Samuelson, Tribune reporter
October 2, 2011
Each round of Federal Reserve economic stimulus has been met with shouts that the moves will stoke inflation — a general increase in the price of things. And that's a source of concern for Federal Reserve Chairman Ben Bernanke, too, though his primary intent is to avoid deflation — a widespread decline in prices.
After all, inflation, long seen as the economic bogeyman, can help ease a weak economy and retire long-term debt.
We asked Michael Pries, associate professor of economics at the University of Notre Dame, and Gary Langer, professor of economics at Roosevelt University, whether inflation is a positive or negative and its role in today's economy:
What are the upsides to inflation?
Pries: While growth in the money supply causes prices to rise in the long run, most economists believe that in the short run an increase in the money supply can lower interest rates. That's why the Federal Reserve increases the money supply when it decides to lower its interest rate target. Interest rates are lowered to stimulate demand for goods and services: Purchasing a new car or a washing machine is more affordable when interest rates are low. And the hope is that by stimulating demand for goods and services, firms will hire more workers, and unemployment will fall.
Langer: Faster inflation is typically the consequence of prosperity, not the cause of it. But a moderate and predictable upward drift to prices is generally thought to be advantageous. By being predictable, it lends some certainty to making long-term commitments, which is good for investment and productivity growth, and by being moderate it makes policymakers more confident that they can give the economy a boost by lowering interest rates when the economy needs it. However, polls have always shown that inflation makes people feel uncomfortable even if their own incomes are rising faster than prices. All things considered, monetary policy wonks think a good target of moderate and predictable inflation is between 2 and 4 percent per year.
The downsides to inflation?
Pries: When inflation is relatively low, say 5 percent or lower, it isn't very harmful so long as it is relatively predictable. That is, if I know that inflation is going to be 4 percent, then as an employer I can factor that into a cost-of-living allowance for my workers; as a banker I can factor that into the interest rates I charge, etc. However, if the inflation is unpredictable, it makes it difficult to plan for the future. When the inflation rate is much higher, even if it is predictable, it becomes harmful because it makes it very expensive to hold money.
Langer: Inflation harms the most those who cannot successfully bargain for wage increases to keep pace with prices. These are typically the least organized, least skilled and least connected. This is another of the popular myths associated with inflation, that when prices rise faster than wages, it's inflation that is to blame. What's more likely to be the case for most people in today's economy is that prices are rising faster than wages because employee bargaining power has been so eroded by high unemployment. Fear of job loss makes employees timid. An old English saying is that, "Wages rise when two masters chase the same man, and fall when two men chase the same master."
Unanticipated inflation also harms rentiers (bondholders), whose income is fixed in money terms. Anticipated inflation is built into decisions to invest in fixed-income securities. When actual inflation turns out to be more than expected, rentiers take a loss because they get back dollars that are less valuable than the dollars that they expected to get. But rentiers can also reap a windfall when inflation turns out to be less than expected.
What is a "normal rate" of inflation and how does our current rate (an August report pegged it at 3.8 percent) compare?
Pries: The Federal Reserve unofficially targets an inflation rate of about 2 percent per year. In other countries, the target is official. The advantage of having a target like this, official or unofficial, is that it makes things relatively predictable. In some years, inflation will be a bit above target, and in others it will be below target, but if the Fed has a target and it is credible, people can get an idea of what level of inflation they should expect.
Langer: For most of the past 20 years, the inflation rate has been 2 to 3 percent. Right now, if you look at inflation on a year-over-year basis, it is running at 3 to 4 percent. But this is mainly the result of increases in the relative price of oil and foods. These increases are likely to be over or in the process of reversing. If so, the rate of inflation is likely to revert to its normal path of closely tracking the rate of growth of money wage rates. The reason prices and wages move in close tandem is that the prices of services and manufactured goods are typically set by marking up production costs, which are largely wage costs. The most recent year-over-year rate of increase in money wage rates has been just less than 2 percent, down sharply from 4 percent at the end of 2007, before the start of the recession.
When does inflation become a problem?
Pries: It's hard to choose a specific inflation rate that would represent the danger line. Clearly, 40 percent per month is undesirable because it forces people to go out of their way to avoid using cash. But is 10 percent much worse than 2 percent? I would say it isn't, so long as it is predictable. Suppose that everyone expected inflation to be 2 percent per year, but Fed policy started to generate 10 percent annual inflation. As a banker, I may have granted a loan at a 5 percent interest rate, with the idea that 2 percent would cover inflation and the other 3 percent would be a real return on my loan. When inflation soars to 10 percent, the loan will be repaid in dollars whose purchasing power had been significantly inflated away. The real purchasing power of the loan repayment would have declined by 5 percent. This scenario would be a great deal for borrowers. But it would be a terrible deal for lenders, and it would wreak havoc on the banking system.
Langer: Except to the extent to which it is unpredictable and annoying, no rate of inflation is much bother to any consumer whose income rises faster.
Bernanke is concerned about deflation and said Wednesday that the Fed might need to ease monetary policy further. But what tools does it have left?
Pries: The Fed's main policy tool is to affect short-term interest rates by increasing or decreasing the money supply. Right now, the Fed has fully exhausted what it can do with that tool because short-term interest rates are at zero. And nominal interest rates can't be negative; why would anyone accept a negative interest rate if they could just hold money?
Because the Fed cannot drive short-term rates down any further, it has resorted to less conventional policy tools: quantitative easing.
The Fed has undertaken two rounds of quantitative easing by purchasing more than $1.5 trillion in long-term bonds and other long-term assets. With the economy still sputtering, it recently initiated Operation Twist.
This would seem to indicate the Fed's arsenal is now pretty much empty.
Langer: For all intents and purposes, the Federal Reserve ran out of ammunition in the conduct of conventional monetary policy in December 2008 when it dropped the Fed funds rate to near zero, where it has remained and where the Fed pledges to keep it until 2013.
The best that the Fed can do is to accommodate a strongly expansionary fiscal policy. But such a policy requires the president and Congress to take the lead and act.
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