Inflation

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The inflation solution

IT HAS long been considered a scourge, an obstacle to investment and a tax on the thrifty. It seems strange, then, that inflation is now touted as a solution to the rich world’s economic troubles. At first sight the case seems compelling. If central banks had a higher target for inflation, that would allow for bigger cuts in real interest rates in a recession. Faster inflation makes it easier to restore cost-competitiveness in depressed industries and regions. And it would help reduce the private and public debt burdens that weigh on the rich world’s economies. In practice, however, allowing prices to rise more quickly has costs as well as benefits.

The orthodoxy on inflation is certainly shifting. A recent IMF paper* co-authored by the fund’s chief economist suggests that very low inflation may do more harm than good. Empirical research is far clearer about the harmful effects on output once inflation is in double digits. So a 4% inflation target might be better than a goal of 2% as it would allow for monetary policy to respond more aggressively to economic “shocks”. If the expected inflation rate rose by a notch or two, wages and interest rates would shift up to match it. The higher rates required in normal times would create the space for bigger cuts during slumps.

That argument is often bundled with another: that higher inflation greases the wheels of the economy. Wages should ideally be tied to productivity, but workers are usually reluctant to suffer the pay cuts that are sometimes required to maintain that link. A higher inflation rate can make it easier for relative wages to adjust. A cut in real wages is easier to disguise with inflation of 3-4% than a rate of 1-2%. If the European Central Bank (ECB) had a higher inflation target, say, then Greece, Ireland and Spain would be able to regain competitiveness more quickly while avoiding unpopular cuts in nominal wages.

The anxiety about indebtedness makes inflation seem all the more appealing. Spending in rich countries, such as America and Britain, will flounder as long as households look to pay down the debts they acquired to buy expensive homes. A burst of inflation would speed up this process by eroding the real value of mortgages. Inflation would work the same magic on government debt. It could also give a fillip to revenues. Tax allowances and thresholds are not perfectly indexed and inflation pushes taxpayers into higher income brackets where they face heftier tax rates.

In principle a modest dose of controlled inflation might work wonders. In practice, however, it may be hard to achieve and the benefits may not be quite as obvious. Take public debt. Inflation certainly helped reduce America’s government-debt burden after the second world war, but far more of the shrinkage came from strong GDP growth and primary budget surpluses. George Hall of Brandeis University and Thomas Sargent of New York University† reckon that less than a quarter of the reduction in America’s debt-to-GDP ratio between 1945 and 1974 came from negative real rates of return on government bonds.

The Hall-Sargent calculations show that almost all of this inflation tax was borne by those who held bonds with a maturity of five years or more. (That is because investors in short-term bonds could more quickly demand higher interest rates to compensate for inflation.) The trick is harder to repeat today. The average maturity of federal debt was more than seven years in the 1940s. According to Bloomberg, the weighted average maturity of all American public debt is now around five years. Using inflation to stiff investors works best when the bulk of borrowing is in the past: governments have an incentive to keep inflation (and thus bond yields) low as long as they are issuing fresh bonds to cover their huge budget deficits.


Another obstacle to higher inflation is that rich countries have promised themselves price stability. A central bank could not credibly commit itself to a 4% inflation target having broken a pledge to keep inflation close to 2%. Bond investors would demand an interest-rate premium for bearing the risks of a future increase in the target, as well as an extra reward for enduring more variable returns (higher inflation tends to be more volatile). Moreover, many social-security and health-care entitlements are indexed to prices, as is a chunk of public debt, so higher inflation would drive up public spending.

Soak the pensioners

For the private sector, too, inflation would be a mixed blessing. Take Britain, which might seem a likely candidate for inflation: its government sets the central bank’s inflation target and it has issued lots of long-term bonds (see left-hand chart). Alongside a rapid build-up of debt by some households there has been an increase in cash deposits by others (see right-hand chart). Using inflation to transfer wealth from savers to debtors may help boost spending. But there are limits to how much you can do this in a country such as Britain (or Ireland or Spain), where both saving and mortgages are linked to short-term interest rates. Inflation would over time reduce the real burden of debt but would raise interest costs more quickly. Nor would it be politically popular: savers tend to be older and the old vote more often.

A burst of unanticipated inflation that was not expected to last would be a salve to the most troubled rich economies, but it is not something that can be easily engineered. Even so, how much regret would even the most hawkish central banker feel if inflation rose above 2% for a while without making bond investors nervous? The best policy may well be to talk tough about inflation while keeping interest rates low for as long as possible.

  • “Rethinking Macroeconomic Policy” by Olivier Blanchard, Giovanni Dell’Ariccia and Paolo Mauro, IMF Staff Position Note (February 12th 2010).

†“Interest Rate Risk and Other Determinants of Post-WWII US Government Debt/GDP Dynamics.” NBER Working Paper No. 15702 (January 2010).

Inflation dynamics

This paper studies inflation dynamics during 25 historical episodes in advanced economies where output remained well below potential for an extended period. We find that such episodes generally brought about significant disinflation, underpinned by weak labor markets, slowing wage growth, and, in many cases, falling oil prices.

Indeed, inflation declined by about the same fraction of the initial inflation rate across episodes. That said, disinflation has tended to taper off at very low positive inflation rates, arguably reflecting downward nominal rigidities and well-anchored inflation expectations. Temporary inflation increases during episodes were, in turn, systematically related to currency depreciation or higher oil prices. Overall, the historical patterns suggest little upside inflation risk in advanced economies facing the prospect of persistent large output gaps.

References

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