Is A Little Inflation Good For The Economy?

October 28, 2013 at 7:30 am Leave a comment

Sunday’s New York Times included the type of headline which borders on heretical to anyone who has been keeping an eye on monetary policy since the days of Paul Volcker:  “In FED and Out, Many Now Think a Little Inflation Helps.”  Don’t underestimate how big a deal this assertion is or how much it could further politicize the nomination of Janet Yellen to be the next chair of the Federal Reserve  Board.

Conventional wisdom has it that in the early 1980s Paul Volcker ruthlessly raised interest rates in order to tame inflation.  His actions may have exacerbated an economic downturn, but they also laid the groundwork for more than two decades of solid economic gains.  As a matter of fact, while the FED has a mandate to both keep inflation in check and maximize employment, almost every FED chairman has inflation fighting credentials at or near the top of his curriculum vitae.  As explained in the article, this bias reflects the country’s past experience with inflation eating away at the standard of living while producing little countervailing economic gain.

As Keynesian economics became the predominate economic school after World War II, there was wide acceptance of the view that inflation was a necessary trade-off for a growing economy.  More people with jobs meant more people with money; more spending meant more inflation.  However, starting in the late 1960s, Milton Friedman began to argue that over the long-term intolerance of inflation in the name of maximum employment would simply lead to a stagnating economy where prices rise but spending power diminishes and fewer people can ultimately find work.  His views were vindicated by ’70s stagflation laying the groundwork for Volcker’s actions.

But suddenly, inflation doves are coming out of the closet.  I was a little surprised to see the number of people who are willing to talk boldly about the need for the FED to tolerate inflation and even encourage it.  In a blog post yesterday evening expounding on his views, Jared Bernstein, who was formerly Vice President Biden’s top economic advisor, explained that higher inflation rates would have the effect of reducing debt burdens and enticing companies with inflated profit margins to borrow more money for expansions.  You may be charging a member $350 each month now to repay a car loan, but if that same member suddenly sees an increase in salary, you won’t be able to make that member make higher monthly payments.  In addition, a rise in inflation, he argues, might actually increase consumer confidence by increasing the wages of the American worker.

The problem with this argument is that it smacks of desperation at a time when more and more people are trying to figure out what can be done to jump-start the economy.  We’ve been down this road before, and the danger is that if the FED decides to tolerate inflation and is wrong, then there’s nothing it can do to fix its mistake except cut back on the money supply at a time when more money is exactly what we need to further economic growth.  Furthermore, it’s already difficult enough for credit unions to find safe yields.  Can you imagine how much trickier the search will become if inflation starts creeping up in the name of economic expansion?

This may seem like abstract stuff, but it isn’t.  One of the primary arguments in favor of the FED tapering its bond-buying program when it meets this week is the fear that the program has the potential to create a sudden surge of inflation if and when the FED stops artificially manipulating bond prices.  Conversely, proponents of bond buying don’t see inflation as much of a risk.  Now we have some economists who are willing to argue not only that inflation is not a risk, but that it could produce a significant number of economic benefits.  This is a debate that will be played out for years to come.  But let’s remember that those who fail to heed the mistakes of the past are bound to repeat them.

Entry filed under: Economy, General. Tags: , , , , , .

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Authored By:

Henry Meier, Esq., General Counsel, New York Credit Union Association.

The views Henry expresses are Henry’s alone and do not necessarily reflect the views of the Association.

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