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Ending Inflation?

July 7, 2017

A response to:

The Federal Reserve Board seeks to maintain an inflation rate around two percent per year. While this rate might sound low for older types who remember double-digit inflation rates in the late 70s and early 80s, and a rate of 5.4 percent as recently as 1990, why tolerate, let alone seek to sustain, any inflation at all? Why not seek to establish zero inflation and stable prices? After all, even an inflation rate of only two percent a year means nominal prices still double every 36 years.

36 years is a long time. Longer than I’ve been alive, and certainly long enough for people to adjust. Furthermore, since quality adjusting prices is more difficult the longer the time horizon, it could easily be the case that the true inflation over the decades has been substantially lower than what’s measured. Many goods have gotten better over time (electronics, cars, toys) so if you simply compare the price, you’re overestimating inflation. I doubt very many people would want 1980 prices if it meant they could only buy goods with 1980’s quality as well.

The problem of the zero lower bound is overblown. The main cause is the unwillingness on the part of the Fed to target levels rather than rates, do catch up inflation, and communicate their intentions in a language other than short term interest rates. The idea that the Fed could purchase every asset on planet Earth with newly printed dollars and not have inflation budge is frankly absurd, but also depressingly common among macroeconomic commentators.

“…there exists a sizeable contingent of macroeconomists skeptical of the efficacy of interest rate manipulation as a means of responding to recessions”

Yes, but no serious economist doesn’t believe that the Fed can’t influence inflation. Even if the main reason for the business cycle is “real” or supply side factors, there are demand based recessions, such as the one in 2008 and 1930 that even the most die hard RBC advocate must admit weren’t totally caused by technology shocks. When prices drop by 5% suddenly, you’re going to have some fallout. Prices (especially wages) and debt contracts are sticky and sudden changes have real microeconomic impacts.

“the trick with that is preventing people from holding cash when interest rates go below zero. So how to do that?”

All of the solutions in the article seem a bit extreme. If the Fed simply targeted the price level instead of the inflation rate, any drop in prices would be matched by an increase in prices later, so there would be no need to do anything crazy in the short run. Instead, we get a Fed that pursues rate targeting and treats the 2% target as a ceiling instead. It’s really no wonder that when we get 2% deflation for a year (2008), the economy takes a long time to recover from the shock. It’s not about the particular target! It’s about stability. People can adjust to 0% inflation – that’s fine. People can adjust to 2,3, 4, or 5% inflation – all those are fine as well. What matters is that when mistakes are made, they are fixed. The Fed’s mistakes in 2008 were never fixed, they were just left until the market sorted itself out and readjusted its expectations.

The economy is fine now. Yellen has pretty much targeted 1% inflation and unemployment is low and stable. I have no complaints anymore about the macroeconomy. There’s a reason (besides laziness) I haven’t written much about it – things are good and it looks like they’ll keep on being good. Ultimately, if you want to lower the measured inflation rate target to 0%, I think that would be ok, but do it slowly and give people time to adjust to it. Also, there is no need to do anything radical like abolish currency or do negative interest rates on savings accounts or anything like that. Plain old monetary policy is just fine.

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