Major policy changes usually start out as trial balloons, ideas placed with sympathetic media outlets that float around and draw reactions from the affected parties. This gives policymakers a risk-free look at what would happen if they claim credit for a given idea. So the article that appears in today’s Wall Street Journal under the headline Low Inflation Always Best? Some Urge a Policy Rethink is pretty much what you’d expect to see as the U.S. searches for a way out of History’s Biggest Credit Collapse. Still, it’s worth reading closely:
For the past quarter century, inflation has been a bogeyman that eats wealth and causes instability. But lately some smart people—including the chief economist at the International Monetary Fund and a senior Federal Reserve researcher—have been wondering aloud if a little more of it might actually be a good thing.
For several reasons, however, the idea isn’t likely to gain traction any time soon.
The new argument for inflation goes like this: Low inflation and the low interest rates that accompany it leave central banks little room to maneuver when shocks hit. After Lehman Brothers collapsed in 2008, for example, the Federal Reserve quickly cut interest rates to near zero, but couldn’t go lower even though the economy needed more stimulus.
Economists call this the “zero bound” problem. If inflation were a little higher to begin with, and thus interest rates were a little higher, the argument goes, the Fed would have had more room to cut interest rates and provided more juice to the economy.
Right now, the Fed and other big central banks have their sights set on inflation of around 2%. Economists had used a “Three Bears” approach to come up with this number—for a long time it seemed like it was not too hot and not too cold. But low and stable inflation could in theory mean something steady at a slightly higher rate.
IMF chief economist Olivier Blanchard, in a recent paper, said maybe the U.S. central bank’s future inflation goal should be 4%. John Williams, head of the San Francisco Fed’s research department, argued last year that higher targets might be needed to provide a cushion for future crises.
The proposals underscore a broader rethink that is rumbling through the economics profession in the wake of the financial crisis. Many of the things economists thought they knew turned out to be wrong.
It’s a timely conversation. On Friday, the Labor Department said consumer prices excluding food and energy fell in January, the first monthly decline since 1982. Neither Mr. Blanchard nor Mr. Williams was calling for higher inflation now, but their argument opened the door to that discussion.
There are other reasons some would welcome a little more inflation now. Governments in the U.S. and elsewhere, and many U.S. households, are sitting on mountains of debt. A little more inflation could in theory reduce the burden of servicing and paying that off, because while debt payments are often fixed, the revenue and income that households and governments generate to pay it off would rise with inflation.
But there are problems with the welcome-more-inflation argument.
The first is that it isn’t yet clear that the “zero bound” on interest rates that Mr. Blanchard worries about is the economy’s biggest problem. Thus addressing it might not be worth the costs that would be associated with higher inflation.
After the Fed pushed interest rates to near zero in December 2008, Chairman Ben Bernanke found alternatives to more interest-rate cuts: buying mortgage-backed securities and Treasury bonds and funneling credit to auto-loan, student-loan and credit-card markets. Those additional steps were no panacea, but they helped end the recession even if they didn’t produce growth fast enough to bring unemployment down quickly.
“Is that the stuff of a zero-bound disaster?” the Atlanta Fed’s top economist, David Altig, recently wrote on his blog. “Put me down on the petition to not experiment with higher inflation to avoid a problem that was not so clearly a problem.”
There is also a thornier problem. Suppose for a moment that Mr. Blanchard is right, and central banks around the world would be better prepared to fight future crises with a little higher inflation.
Getting from 2% to 4% could be a very messy process. Investors, businesses and households might well conclude a one-time shift to a higher inflation target actually means less commitment to stable inflation. Expectations of higher inflation could become a self-fulfilling prophecy. Instead of getting 4% inflation, central banks could end up with 5%, or 6% or 7%.
A higher inflation goal “would have a fairly immediate and disruptive effect” on markets, said Bruce Kasman, chief economist at J.P. Morgan Chase.
Mr. Bernanke has acknowledged the allure of a higher inflation goal. In written answers to lawmakers in December, he said a higher inflation target could in theory make it possible for the Fed to push inflation-adjusted interest rates lower, stimulating borrowing and economic growth.
But the opposite could happen, too. The prospect of higher inflation could cause interest rates to shoot up and make the burden of future borrowing even heavier. This is a particular problem for countries, like the U.S., that issue a lot of short-term debt and for people with adjustable-rate mortgages.
Mr. Bernanke concluded he didn’t want to mess with people’s fragile expectations. He said switching to a higher target would risk causing “the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy.”
The 2% inflation goal that is so popular with central bankers around the world might not have been the ideal target in retrospect.
But it looks like everybody is tied to it, for better or worse, for the foreseeable future.
A few thoughts:
- The hubris of economists and policymakers who think they actually have the power to tether a system as complex as a modern economy to a specific inflation rate would be funny if it wasn’t so terrifying. Presumably they’ve been targeting an inflation rate all along, and the results have deviated just a bit, in both directions, during the past couple of decades. Raising the target rate would simply raise the amplitude of the fluctuations.
- It’s interesting that the writer recognizes the risks the U.S. runs by financing its deficit with short term borrowing, even comparing us to a homeowner who takes out an adjustable rate mortgage. Yes, we are a subprime nation.
- This is a dance with very predictable steps. A few semi-obscure economists toss out the idea that we need to inflate aggressively, not just as a reaction to a crisis but as a matter of ongoing policy. The U.S., in the person of Ben Bernanke, demurs, citing potential problems and appearing to care about the value of the dollar. Then, as events deteriorate a growing chorus of legislators and economists (look for Paul Krugman to weigh in soon) starts making panicky noises. And finally, Bernanke and the other Fed governors allow themselves, reluctantly, to be convinced of the painful necessity of further debasing the dollar. Which is, of course, what they’ve wanted to do since they aced their first college economics class.
- Now all that’s left is the timing. When will things get so bad that the Fed is forced to swallow its fake reservations and really go for it? That’s unknowable, of course, because it depends on when the next black swan lands. But it probably won’t be long.