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[Warning: Heavy Economics] Inflation

Posted by on Jan. 6, 2013 at 6:06 PM
  • 12 Replies

A good discussion from the Economist on inflation.   Probably only worth wading through if you're having to make some serious financial decisions, though.

The question they asked their experts was:

Above-normal inflation has been proposed as a solution (or salve) to a number of the rich world's economic problems. In conjunction with financial repression, it could help erode sovereign debt loads. In the euro area, differential inflation could facilitate rebalancing. It could help lower real interest rates in economies up against the zero lower bound, and it could help facilitate real wage adjustments in economies plagued by nominal wage stickiness. Of course, there are risks to higher inflation, including efficiency costs and the possibility that "de-anchored" inflation expectations could be difficult and costly to contain.

Will the rich world use above-normal inflation as a way to address economic ills? Should it?

by on Jan. 6, 2013 at 6:06 PM
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Replies (1-10):
Clairwil
by Gold Member on Jan. 6, 2013 at 6:07 PM

Scott Sumner

THERE have recently been a number of calls for a higher inflation target. The proponents claim that this would stimulate economic growth and also ease sovereign-debt crises. I have mixed feelings about these proposals. There are clear advantages to adopting more expansionary monetary policies in the US, Europe, and Japan, but it’s a mistake to target inflation directly, or even to describe the advantages of monetary stimulus in terms of higher inflation.

Inflation can rise due to either supply or demand-side factors. Because most consumers visualise inflation as a supply-side phenomenon (implicitly holding their own nominal income constant) they see inflation as a problem, not a solution. Thus any calls for a higher inflation target are likely to be highly controversial, which makes it unlikely they would be adopted by conservative central bankers.

A much better solution to frankly admit what a growing number of economists are saying; inflation targeting was a mistake from the beginning, and the major central banks should instead be targeting nominal income growth (preferably level targeting). All of the advantages of higher inflation (economic stimulus, lower real debt loads, etc.) are actually more closely linked to rising nominal incomes. A switch to NGDP targeting would not require the major central banks to adopt a new and higher inflation target, with the associated loss of credibility. Instead they should estimate an NGDP target likely to produce 2% inflation in the long run, that is, an NGDP growth rate target of perhaps 4.5% per year in the US, 4% in Europe, and 2.5% in Japan. If the central bank believes there is a need for some “catch-up growth” (and surely that’s the case in the US and Europe, then they should start the trend line from 2008 or 2009, to allow for higher NGDP growth for the next several years.

Some might argue that this is just a back door way of raising the inflation target. Not so. Inflation targeting is what got us into this mess. If we had been targeting NGDP in 2008, level targeting, then monetary policy would have been far more stimulative, the recession would have been much milder, and the sovereign debt crisis would have been confined to Greece and perhaps one other country. We don’t need an expedient like a temporarily higher inflation target, which will further erode central bank credibility. Rather we need an entirely new policy rule, a rule that will be so robust that it doesn’t have to be abandoned every time we face a recession or a debt crisis. A rule that is consistent with 2% inflation in the long run. Nominal income targeting is the policy rule that is most likely to fit that description.

Clairwil
by Gold Member on Jan. 6, 2013 at 6:07 PM

Ajay Shah

WE ARE in danger of losing sight of hard-won institutional achievements. For decades, rich countries have done a good job of delivering 2% inflation. By removing the fear of inflationary episodes, governments have obtained low-cost financing. In the short run, one can always cheat on bondholders once by triggering off an episode of inflation. In return, the bond market will mistrust the institutions of rich countries for many decades.

The fiscal problems of many rich countries are fairly structural. The set of promises that have been made to citizens are not affordable. If the choice is posed as one of reneging on bondholders versus reneging on citizens, then reneging on bondholders appears to be a good choice for a populist government. But in most situations, reneging on bondholders will not be enough to restore fiscal soundness. Even if unanticipated inflation shaves 30% off the debt/GDP ratio, a very big debt/GDP ratio will remain, and the fundamental fiscal dynamics will remain adverse (the precise situation differs from one country to the next). The State will then face a more difficult situation in the future, facing fiscal stress while lacking a supportive bond market. It makes more sense to renege on citizens, as the countries of Europe have been gradually doing in recent years, with a retreat of the unaffordable welfare state.

I am, personally, optimistic about how this will work out. The consequences of destabilising inflationary expectations are far-reaching, and good sense will prevail. If, on the other hand, some rich countries do go down this route of ratcheting up inflation, then we will see a far more difficult macroeconomic situation for them when compared with conditions before the Great Moderation. It was one thing for countries to get religion about price stability in the 1970s and 1980s, and go to the bond market saying "Now we have put monetary policy on a sound foundation; trust us, we will never mess up on inflation again". A rich country that messes up on inflation today will find it much harder to regain the trust of the bond market when compared with the ease with which the bond market was persuaded at the onset of the Great Moderation.

Clairwil
by Gold Member on Jan. 6, 2013 at 6:08 PM

Gilles Saint-Paul

INFLATION would certainly deflate the real value of public debt in most countries. It would also reduce real interest rates, inducing people to spend more so as to get rid of their nominal assets, and may also reduce the cost of labour to the extent that workers have nominal wage contracts.

Yet this would be just a short-term fix and it would not address the structural problems. We have learned in the seventies that inflation only works if it is unanticipated. Otherwise it is reflected in higher nominal interest rates (notably on public debt) and in indexed wage contracts. As it is difficult to fool people more than once, after such a surprise inflation can then easily crawl into the two-digit zone and disinflation may be quite costly: to stop inflation the Fed had to plunge the US economy into a recession in the late seventies/early eighties.

The structural problems are that most European welfare states are trying to finance themselves by running a Ponzi game and that markets are finally realising it, and that labour market rigidities generate upward pressure in real wages that can only be tamed at high rates of unemployment. Clearly a shot of inflation would do nothing to address those problems. Real wage losses would be made up for quite quickly, and markets will ask for a premium on the rate of return on public debt as soon as they realise we have reached a new inflationary regime.

During the early part of the crisis, when in the name of stimulus government let budget deficits slip to 8-10% of GDP, few people believed that some countries might face a sovereign-debt crisis. Such events were supposedly confined to middle-income countries. Now, instead of having an intended temporary burst of inflation, European countries may find themselves permanently in the “banana republic” category, in which case they will face the choice between validating expectations of high inflation by indeed having it, or trying to restore their credibility at great pains. As of now, this sounds implausible, but so was the idea of a sovereign-debt crisis in the euro-zone four years ago.

Indeed, fears of deflation have not materialised during the current recession and inflation in Europe is at around 2% despite the low level of economic activity. This was the same rate as during the booming years, suggesting the output/inflation trade-off has shifted out and that inflationary pressure will resume whenever growth picks up. It will be interesting to see whether the ECB will swiftly restore its credibility or bow to political pressure to inflate away the large sovereign debts that were accumulated during the crisis.

Also, inflation is an opaque and undemocratic way of allocating the burden of adjustment. Austerity plans force elected officials to make explicit choices and are generally subject to parliamentary scrutiny. Instead, inflation is a government-led soft wave of invalidation of private and public contracts, with a diffuse allocation of gains and losses (with the most trusting and virtuous people bearing most of the losses). Of course this is made even worse when such inflation is implemented by a non-elected transnational body such as the ECB, although conceivably member states could officially agree to change its mandate before it can go ahead with a higher target for inflation.

Clairwil
by Gold Member on Jan. 6, 2013 at 6:09 PM

Michael Heise

VIEWED from Germany, I see no appetite for tinkering with inflation as a weapon to solve the world’s economic woes. Deliberately adding a dose of inflation to the already long list of economic headaches would be nothing short of reckless. And, like the sorcerer’s apprentice, inflation can prove hard to tame once unleashed. The arguments are well-rehearsed, covering the impact on interest rates (and government refinancing costs) once inflationary expectations rise, the penalisation of low wage groups and savers, supply side inefficiencies and more.

Savers are having a hard enough time as it is. The recently released third edition of the “Allianz Global Wealth Report” highlighted their plight.

At first glance, global wealth development paints an impressive picture: last year, the financial assets of private households worldwide topped the EUR 100 trillion mark. This is a staggering amount, enough to allow savers to buy the outstanding government bonds of every country in the world three times over. If we scratch beneath the surface, however, the development proves to be anything but spectacular. Since 2000, per capita financial assets have been growing at an average rate of 3% a year—roughly on a par with the global rate of inflation during this period. In other words: over the past eleven years, savers have not, on average, managed to achieve any real value gains.

The reason behind this development is obvious: the accumulation of household wealth has been hampered by the recurring crises and losses on the financial markets and the low interest rates monetary policies have deployed to combat these crises. In 2011, western Europe even saw a contraction of gross nominal assets and an even stronger decline of real wealth. This definitely provides food for thought. The longer it takes for the financial markets to recover and the euro-zone debt crisis to be overcome, the greater the risk of “losing” a whole generation of savers because the idea of long-term investment is eyed with deep mistrust. Given the long-term challenges that lie ahead, e.g. big investment needs in infrastructure, climate protection and demographic change, we cannot afford to take the short-sighted approach. Confidence in the financial markets, which serve to balance out risks and returns in the long term, is a must if we want to achieve sustainable growth and prosperity. Significantly higher inflationary expectations would undermine confidence and increase short-termism. Therefore, the inflation option is not as tempting as it may seem at first sight. Plus/minus 2% is adequate to stay away from the zero bound, but anything around or above 4 or 5% would have the above ramifications.

Clairwil
by Gold Member on Jan. 6, 2013 at 6:09 PM

Mark Thoma

BOTH the US and Europe could benefit from temporary period of above-normal inflation. In Europe, a temporary increase in inflation would help countries struggling with sovereign-debt problems. It would also facilitate needed adjustments within the euro zone that are difficult to achieve when countries share a common currency. In the US, a period of above-normal inflation would provide needed stimulus to the economy by lowering real interest rates, making US exports more attractive, and reducing household debt loads.

Along with these benefits there are, of course, potential costs. As at the top of this page notes, these include both efficiency costs and the possibility that inflation expectations will become "de-anchored". However, the efficiency costs of a temporary increase in the inflation rate are relatively low—an extra percent or two for a period of time followed by a return to normal in the long-run won't do much damage.

And there is very little reason to think that inflation expectations would begin to drift upward as a consequence of pursuing such a policy. Both the Federal Reserve and the ECB have sufficient credibility to announce that they are going to target a higher rate of inflation, continue to pursue such a policy until unemployment falls below a predetermined level, and then return inflation to normal. So long as they are believed to be credible—and they are—inflation expectations should track the announced path for actual inflation.

So the expected benefits from providing even modest help to economies struggling to escape the recession are large, and the expected costs are relatively low. Thus, the answer to the question "Should the rich world use above-normal inflation as a way to address economic ills?," is a clear yes.

As to the question of "Will the rich world use above-normal inflation as a way to address economic ills?," that's not likely in the US or Europe. The Fed would probably tolerate, nervously, a short-run period of inflation above 2% during the recovery, though not much over 2%. But while the Fed may tolerate a temporary increase in inflation if it happens, it is not likely to announce and then pursue a higher inflation target. And although Europe could surely use the help—this is the time to exploit the hard-earned credibility that was earned in the past—it's even less likely that the ECB would tolerate a burst of inflation.

That's too bad, because with fiscal policy all but off the table in both the US and Europe, we need all the help from monetary authorities that we can get.

musicmaker
by Member on Jan. 6, 2013 at 6:46 PM

 Clair, you are oviously way smarter than me, i am just a lowly elementary school music teacher. Can you put this into economics for dummies language?

Clairwil
by Gold Member on Jan. 6, 2013 at 7:13 PM
Quoting musicmaker:

 Can you put this into economics for dummies language?

If I owe you $100, and I can spare $10 a month from my wages towards paying it back, it will take me 10 months to pay you back.

If there's massive inflation, so the dollar becomes worth half what it used to be worth, then I'll still owe you $100, but (assuming my wages keep up with inflation), I'll now be able to spare $20 a month, and can pay back the debt in just 5 months.


America (and Europe) have large national debts.   If the Dollar and the Euro undergo a period of high inflation, then the debts will be easier for the governments to pay off.

However, there's a price for doing that.  Firstly, the dollars in the bank accounts of the citizens also get hit.  And, secondly, if the financial markets think you might do the same thing again the next time you get into debt, they'll punish you for that in the long term.

romalove
by SenseandSensibility on Jan. 6, 2013 at 7:23 PM


Quoting Clairwil:

Quoting musicmaker:

 Can you put this into economics for dummies language?

If I owe you $100, and I can spare $10 a month from my wages towards paying it back, it will take me 10 months to pay you back.

If there's massive inflation, so the dollar becomes worth half what it used to be worth, then I'll still owe you $100, but (assuming my wages keep up with inflation), I'll now be able to spare $20 a month, and can pay back the debt in just 5 months.


America (and Europe) have large national debts.   If the Dollar and the Euro undergo a period of high inflation, then the debts will be easier for the governments to pay off.

However, there's a price for doing that.  Firstly, the dollars in the bank accounts of the citizens also get hit.  And, secondly, if the financial markets think you might do the same thing again the next time you get into debt, they'll punish you for that in the long term.

What I made bigger.

Why are we making that assumption?

What happens if that doesn't happen but the prices for everything goes up?

I specifically am asking this because I think Americans are about to be hit hard in the pocketbook.  Gas, food, insurance all going up, taxes going up, property taxes going up, but wages not keeping pace as we still have relatively high unemployment.


Clairwil
by Gold Member on Jan. 6, 2013 at 7:26 PM
Quoting romalove:

Why are we making that assumption?

Because it was an analogy.   The actual thing we're talking about is national debts, and governments are not paid a wage.   When they allow inflation, that doesn't affect the real assets of the country (eg barrels of oil), at least not directly.

romalove
by SenseandSensibility on Jan. 6, 2013 at 7:27 PM


Quoting Clairwil:

Quoting romalove:

Why are we making that assumption?

Because it was an analogy.   The actual thing we're talking about is national debts, and governments are not paid a wage.   When they allow inflation, that doesn't affect the real assets of the country (eg barrels of oil), at least not directly.

So as a citizen and not a government it's OK if this all scares the crap out of me?

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