The Return of Inflationism?

by Mario Rizzo

The Fed has become desperate, not because the American economy is currently falling apart, but because the economy has stubbornly failed to respond well to the policies of the “best and the brightest.” And now, as if to welcome the impending chairmanship of Janet Yellen, stories are surfacing in various places about the growing consensus inside and outside of the Fed for inflation. There is not enough inflation to stimulate adequate economic growth. Just a little more, or maybe even a lot more (perhaps as high as 6 percent) is needed as Ken Rogoff of Harvard is suggesting.

The arguments being used today are not exactly the same as those of the 1970s, yet I have the feeling that I have been here before.  It is important to distinguish theory from what policy economics is about. Policy economics often comes down to rather simple ideas. The real world has a way of making a mockery of today’s sophisticated macroeconomic theory. For one thing, policy has to be relatively simple if it is to be transparent.

So “we” want more inflation. The first thing to consider is how to get it. Bank reserves are high but interest is paid by the Fed on them. So presumably we could stop doing that. On the other hand, the Fed wants the banks to be better capitalized to avoid liquidity and possibly solvency problems. The easiest thing then would be to flood the system with still more bank reserves but not pay interest on these additional reserves. However, what might work to raise the rate of inflation by a small amount on the current conditions might be too much for comfort later on.

So once we get the rate of inflation up, what happens then? We should have a once-and-for-all decrease in the demand to hold money out of income and assets as the cost of holding money rises. This will produce a further spike in the price level – perhaps confusing economic agents about the new steady state inflation rate. They may believe it will be higher than the Fed wants them to believe or intends.

How is all of this supposed to raise output and employment? If the prices of outputs rise relative to inputs, firms may expand production. Some inputs like raw materials are likely to rise at the same pace as output prices. And what is input to some firms is output to others. In order to avoid shortages the input prices of some goods will have to rise as well. Expanding profit margins must depend on some inputs not increasing in price as fast as output prices.

We are back to the money illusion. Suppose labor is deceived and its price relative to those of other inputs and outputs falls. So they are hired and work more at less real pay than they thought they were getting. How long will this last before the Fed must ramp up the inflation?  We know the rest of the story from the 1970s and early 80s.

What also irks me about this is that if it works as intended then it is redistribution from, say, the elderly to those who are newly employed (except that they are employed under a money illusion). The elderly who are conservative about their savings have already suffered from near zero interest rates.

But the problems lie also in the distorted production and investment effects. If longer-term real interest rates fall further then there will be more activity in the producers’ goods industries than will be sustainable when real rates later rise. There will also be more risk taking in financial investments as the real rate falls.

Keep in mind that someone has to be deceived in the system for the output effects to take place. The question is who, where, and for how long?

It would be a lot better if greater attention were given to the micro-causes of stubborn unemployment and falling labor participation rates. To discuss the roles of the massive expansion of food stamps, unemployment insurance extensions, easier disability eligibility, upcoming Obamacare costs and uncertainty, and so forth is more difficult for those who do not want to offend “progressive” constituencies.  Luckily, many of us do not mind being offensive when it can do some good.

9 thoughts on “The Return of Inflationism?

  1. RE: “It would be a lot better if greater attention were given to the micro-causes of stubborn unemployment and falling labor participation rates.”

    On target as always. 🙂

  2. The idea of inflation as a panacea, or even a clear improvement, comes from a failure to understand the dynamic actors involved. Only one side of the model is examined and it has a “clear” result, inflation increases employment.

    For example, game theorists have models such as Barro and Gordon (1983) where the central bank tries to trick employees into agreeing to contracts with pay increases below inflation. Therefore, the coming inflation can drive down unemployment since other people are getting “underpaid.” The problem is that only the supply side is looked at. The price of wages is lower so people supply more labor- one sided analysis.

    This completely ignores the discovery/catallactic nature of the economy. Supply influences demand influences supply, ad infinitum. The models are just not up to the task of policy evaluation.

  3. I wonder if the Fed can really create more inflation. Japan has not succeeded very well. Someone has to borrow in order to expand the money supply through banking. Businesses aren’t borrowing because the US is a poor investment due to high taxes and regulations. The government won’t borrow much more as long as some Republicans are in Congress.

    The Fed could buy more bonds, but the sellers will probably just buy another asset, such as stocks or real estate. It’s not likely they will just spend their cash.

  4. Rogoff has been callig for high inflation for a while. The interesting thing is why he and ohers are now getting attention; and the New York Times choose to write about it. Timing is everything in politics.

    What seems to matter here is the prospect of Yellen’s ascension to the Fed chairmanship. Are the inflationists hoping to infleunce her policy, or give her cover for what they expect her to do?

    Yellen will be coming into her new role with a very restive FOMC. Now it is not just some bank presidents, but some governors who want to “.taper” bond purchases. If we take her at her word, she wants more inflation. If we take the reality of the FOMC, she may be stymied.

    The classic article on the effects of inflation is the one by that written by Alchian and Kessel. I just reread it.

    I added my voice to the critics of the inflationists on Fox Business News yesterday. As one prominent monetary economist said of the inflationists, they learn nothing and forget everything.

  5. Two comments: first, isn’t it apparent that historically low interest rates since 2009 have not produced the hoped for increase in the pace of recovery? (What it has achieved is a huge asset bubble in financial markets. And bubbles burst.) This suggests that the obstacles to the recovery principally lie elsewhere than with monetary policy: “macro problems require micro solutions.”

    Second, the enormous overhang of excess bank reserves resembles the sword of Damocles. Even if the Fed does lower the interest rate it pays on excess reserves, what matters is the spread between market rates and the returns to holding excess reserves. Take a look at the yield curve since last year and you’ll see long rates edging ever-upward. As the recovery continues (however slowly), pressures are mounting for rates to raise and at some point banks will start to lend with purpose and then we will see the stock of money explode.

    The Fed has yet to announce a feasible “exit strategy” because it is caught between a rock and a hard place: monetary restraint (eg., slowing the purchase of long term govt securities) will send the markets into chaos (recall what happened when Ben hinted at this a few months ago) while, on the other hand, alllowing market rates to rise is risky due to the excess reserve problem.

    We’re in for one hell of a show.

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