Can a Little Inflation Be Good?

by Philip Brewer on 17 February 2010 12 comments
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Let me jump to the end and say right at the start that I don't think so. However, there's a serious argument being made right now among economists and economic policy makers that higher inflation would be good. There's enough of them in the pro-inflation camp that it's worth taking a look at what they're saying.

The Economist has a good article summarizing the current economic thinking that very low inflation can lead to trouble.

The basic case of the pro-inflation camp is that certain kinds of economic adjustments are very hard to make under a condition of stable prices. The classic example is wages, which are (in the term economists use) "sticky on the downside." That is to say that workers will resist wage cuts very strongly — strongly enough that employers find it easier to cut jobs than to cut wages.

When an economic downturn hits during a period of very low inflation, it's hard to adjust. Output goes down, jobs are lost, businesses go bust, asset prices fall, etc. (In other words, exactly what we're seeing right now.)

When there's a little inflation, it's possible to make much the same adjustments with less loss in output. Instead of trying to cut wages, employers can achieve the same result simply by giving raises lower than inflation. That means that fewer jobs are lost, fewer businesses go broke, asset prices don't have to fall as far, and so on. Economists like to speak of a little inflation as a "lubricant" in the adjustment process.

In addition to making the adjustment smoother (all wages and prices go up, but some go up slower than inflation, which amounts to a cut), a little inflation can stimulate the economy, by prompting people to buy now before prices go up (i.e. before the value of their money falls even further).

I've talked before about the downsides of inflation. When prices are stable over the long term, people can focus more of their attention on productive activities and less on keeping track of price changes.

Worse, though, I think higher inflation rates are inherently unstable. An inflation rate under 2% is low enough that inflation can just about be ignored, and a consensus can develop that it's okay. A higher inflation rate, though, becomes noticeable — and there will be pressure to change the inflation rate. Whether the pressure to raise the inflation rate will win over the pressure to lower the inflation rate can't be known, so everyone has to keep their plans flexible so that they can adjust to either possibility. That makes it much tougher to make long term plans — and that, I think, costs our economy quite a bit.

Maybe my thinking is overly influenced by my own experience — I was setting up my first household in 1980-1981, right at the peak of the 1970s inflation. But I don't think inflation is ever a better answer than stable prices.

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Guest's picture

I think a small amount of inflation is especially good for existing homeowners. If you have a $1,000 mortgage payment that remains constant, as inflation is realized, the effective payment will diminish over time. Assuming you get raises that are at or near the levels of inflation, this means that your cost of living will slightly decrease over time.

I agree, though, that a moderated level (1-2% annually) is ideal.

Philip Brewer's picture

Yes, a little inflation means that a fixed-rate mortgage gradually becomes easier to pay. The result is that a buyer who over-reaches just a little—buying slightly more house than he can afford—will often be bailed out over time.

Economists like to point out that expected inflation doesn't really change anything: If everyone expects the inflation rate to run about 2%, then the interest rate on the mortgage will be about 2 percentage points higher than it otherwise would be. Then, if inflation runs a little above 2%, the homeowner wins. If, however, inflation runs a little below 2% (as it was doing for the past year or so), the home owner loses.

When you have a little tiny bit of inflation (1–2%), the homeowner can take that risk. When inflation rates get just a little higher (the inflation advocates in that article are suggesting that 4% to 6% inflation might solve a lot of problems) you're setting people up to take huge risks. If you take out a fixed rate mortgage when inflation is running at 5%, you can expect your mortgage rate to come in at 8% or higher. Then, if inflation is brought back down under 2%, you are seriously screwed (unless you can refinance).

It's exactly what I'm talking about when I say that it becomes impossible to make long-term plans when inflation rates rise.

Guest's picture

If you look at current inflation #'s from the last few decades, it's been closer to 3-4% than 1-2%.

Higher inflation along with baby boomers loosing a lot of value in their portfolios recently, doesn't make for an exciting outlook for many people.

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jim

A little bit of inflation is a natural consequence of a growing economy. So yes a little bit of inflation is a good thing as its a reflection of growth.

Philip Brewer's picture

@ Jim:

I don't think that's true. Inflation is a natural consequence of the money supply growing faster than the economy.

You can have inflation even when the economy is shrinking (as, for example in all the recessions in the 1970s and 1980s), and you have have deflation even when the economy is growing. (The latter is uncommon, but it does happen. The long deflation in the US after the civil war, for example, saw strong economic growth.)

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buckiller

I see a big jump in inflation coming. (4% in a year at least)

My reasoning: according to some salary reports I read from ieee and a nyt article, cs and computer eng majors out of college are getting 7% higher salaries than a year before compared to about 2% of other engineers. You can also look on payscale.com and see that as a cs grad you get payed a lot more at somewhere like northrop grumman that has the us gov as a #1 customer than elsewhere. The idea is that the gov prints the money and spends it, the additional money in the markets isn't really accounted for until it trickles down a bit from salaries and gov contactor profits.

Where should one invest when a jump in inflation is on the horizon?

Guest's picture
Guest

Buy gold as an inflation hedge.

In no scenario is inflation preferable to price stability as a constant inflation rate is impossible due to the intrinsic interests of The Global Banking System. Fluctuating inflation forces the common man to become a speculator, and being "unable to plan for the future," is obviously not a scenario he favors.

In a stable price environment, to guard against job losses and business closure as a result of the "sticky to the downside" nature of wages(a psychological problem, not a REAL problem) workers must SAVE more of their income--it's purchasing power being preserved as a result of no inflation--and entrepreneurs(businesses) must be suitably capitalized and manage their operations and expectations(profit goals) more realistically.

Inflation is merely a breading ground for speculators, middlemen and sloppy, wasteful capitalism.

People need to realize they must put more thought into what the "do for a living in life." They must become more educated about things outside of their specializations and realize that all jobs are not created equal.

Many people are simply lucky to have a job at all and given a stable money supply and a high saving rate, they could certainly plan for the time in which they will likely become obsolete.

These thoughts are changeable and a work in progress, BTW.

If you wouldn't mind, consider this new movement doon't use banks visit the links and familiarize yourselves with all possible angles of reality.

Guest's picture
Brian

I tend to think a little inflation is good if only for the fact it is a buffer against deflation. Deflation would be devastating for the US economy (see Great Depression) and the Feds have very little control since deflation is such an emotion driven scenario. Personally, I think deflation is on the horizon (unfortunately). The downward pressure on prices and nagging unemployment (plus a artificially weak yen) will keep prices going down. I DO think it is needed to counteract the "real" and unsubstantiated inflation that happened over the last 30 years (asset price appreciation + real estate).

Also, inflation isn't simply money supply. Inflation is money supply + money velocity. This is why the government was willing to dump "liquidity" into the market during the credit crunch. Since the markets had essentially frozen, the government was trying to load the system with capital with the plan of tightening supply once the markets opened up. Right now the markets aren't opening up (which isn't helping prevent deflation). The large lubricators of the market, i.e. Goldman Sachs would rather take money from the fed @ 0.5% and loan it to the treasury @ 3.5%. This way, they can take there GUARANTEED 3% spread (backed by the full faith of the US taxpayer) and distribute it amongst their executives.

Philip Brewer's picture

 Deflation is only devastating under certain circumstances. It tends to crush people with debts (while benefiting people with cash assets), so under circumstances where many people are deeply indebted, it is hard on many people.

In a low-debt environment, it's pretty harmless.

It does have a couple of good effects. One, of course, is to discourage excess debt. We'd be a lot better off now if all through the 1990s and 2000s people had thought that deflation was a real possibility. The other is that, if we expect the average inflation rate to be zero (because we expect any inflation will be reversed with a corresponding deflation), interest rates can be very low, allowing for very long term planning. (I talk about how very low interest rates enable very long-term planning in my post How low interest rates might save the world.)

Granted we have very low interest rates now, but it's a temporary thing that everyone knows will disappear, so it doesn't encourage long-term planning.

Guest's picture
Brian

"In a low-debt environment, it's pretty harmless."

This is not where we are today. As individuals OR as a nation. Not by a longshot.

Guest's picture

It's obviously don't use banks, by the way. Sorry for the typo.

Guest's picture

Inflation is really only good if as you mention your wages increase along with it