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Folks who have a vivid recollection of the Great Inflation of the 1970s must wonder why anyone would wish even a trace of that upon future generations.
Yet that seems to be the risk that some economists are willing to take.
The idea that the Federal Reserve could “fix” things faster with a bit more inflation keeps popping up in academic circles, which is probably where it should remain.
In December 2008, as the financial crisis started to claim its victims, Harvard University economist Kenneth Rogoff teed up the “inflation option”. Soon, Harvard colleague Greg Mankiw was advocating higher inflation as a cure for slow growth – and a preferable option to additional fiscal stimulus.
In 2010, Olivier Blanchard, the chief economist at the International Monetary Fund, put his imprimatur on the idea. In a paper examining the lessons from the financial crisis, Blanchard and his co-authors suggested that the benefits of a 4 percent inflation target, to minimise the risk of deflation in response to shocks, might outweigh the costs.
Let’s leave aside for the moment the punishing effect higher inflation has on savers, whose investments are paid back in devalued money. I needed to understand the mechanics of what seems like a wacky, and unworkable, idea. So I posed some questions to Rogoff. He said that if the Federal Reserve – or any central bank – were to raise its inflation target, that would lift inflation expectations and reduce short- and intermediate-term real rates. (The real rate is the nominal rate minus expected inflation, which nowadays can be inferred from the spread between nominal and inflation-indexed bonds.)
In theory, this wouldn’t affect real long-term rates, Rogoff said. In practice, I’m not so sure. Rogoff does not like Blanchard’s idea of adopting a permanent 4 percent inflation target. He said a “short burst of moderate inflation” – two years of 6 percent inflation – would speed up the deleveraging process.
Why bother with ceiling?
The operative words in that policy recommendation are “short burst” and “moderate inflation”.
For all its concerted effort – almost five years of zero-percent interest rates, large-scale asset purchases and forward guidance – the Fed can’t even hit its 2 percent target from below. I’m not saying the current 1.3 percent inflation rate is an alarming development that needs to be addressed. I’m just wondering how an institution is going be successful targeting something – inflation – that is determined by today’s monetary policy with “long and variable lags” (see Milton Friedman).
A “short burst” could be prolonged. “Moderate inflation” might be anything but. And inflation expectations might take on a life of their own. If a 6 percent inflation target would accelerate the deleveraging process, why stop there? Why not 8 percent? Or 10 percent? Wouldn’t that speed up the process? You get the point.
Then there’s the small matter of central bank credibility. Everything we hear and read about central banking today emphasises the importance of communicating objectives clearly in order to influence the public’s expectations and behaviour.
Why would central bankers, who have fought hard to earn credibility with financial markets, forgo that trust for short-term gains? And why would we believe anything they ever told us again?
“It’s a slippery slope,” said Marvin Goodfriend, a professor of economics at Carnegie Mellon University and a former research director at the Federal Reserve Bank of Richmond. Talking up inflation introduced the idea that if the central bank were willing “to do something for short-term purposes today, it would do it again for short-run purposes”.
Bad ideas never die. Just this week in a blog post, economist Noah Smith advocated higher inflation – 4 percent or 5 percent – for the next decade. The only downside to higher inflation, he wrote, was the “nuisance cost” of changing prices.
Not to worry. The idea of raising the inflation target “has no traction among central bankers”, Goodfriend said.
That won’t stop academics, who are enthralled with an idea that looks good on paper. However, it’s a comforting thought to those of us who live outside the ivory tower.
Caroline Baum is a Bloomberg columnist.