Can the anti-inflation reflex be tamed?
What we need, Smith said, is to “increase the money supply” — to put more actual money into the economy. Normally, when the Fed wants to do this it can lower interest rates to encourage borrowing, but those have already been brought near zero. Another method to bring real rates down further in the short term would be to reduce the future cost of repaying debt that people take out today, a fundamental effect of inflation.
Other economists – including Scott Sumner, an economist at Bentley University in Massachusetts, and a self-described “inflation hawk” – have outlined another benefit that moderately higher inflation could provide under the current circumstances. Because Americans had expected prices to continue going up about 2 percent a year (the norm since the early 1990s), they made economic decisions (like contracts they signed, and debt they incurred) based on that expectation. Thus, it was a shock when, in 2008, that trend was disrupted, and prices abruptly fell, or simply rose in some sectors much slower than expected.
Suddenly, people who had things to sell — homes, commercial goods, their labor — found themselves in a hole, which only increased their demand for money. If prices were to start rising again by 2 percent a year, they could arrest their economic slide: the deviation between what they planned for and what actually happened wouldn’t grow worse. But they will not eliminate the gap between their expectation for price rises of 2 percent per year and the reality of prices below that level unless extra inflation – that is, inflation beyond the level they had originally anticipated – is generated to fill the hole that developed in recent years. Anything less than that, Sumner says, amounts to “digging sideways.”
Just how, and how quickly, the Fed might create higher inflation is a matter of some debate, but there is reason to believe that were the bank to articulate publicly its plan, it would make a difference. And under the circumstances, Smith believes, setting a higher inflation target now — along with a credible commitment to keep the money stock high even after the economy recovers — is “probably the most important policy change you could make.” He maintains a list, dubbed the “4% Club,” of other economists and commentators who support the move.
Such an approach would be distinctly at odds with the Fed’s past practice; indeed, the Fed over the last two decades has been skittish anytime inflation tops even 3 percent. But while it’s true that poorly run economies often have very high inflation, the evidence for the harm of moderate inflation is much less clear. One 1995 study, for example, estimated that an increase of 10 percentage points in inflation corresponded to a reduction in annual growth of about 0.2 to 0.3 percentage points. Laurence Ball notes that after Paul Volcker, Greenspan’s predecessor, broke the runaway price increases of the early ‘80s, the inflation rate was maintained at about 3 or 4 percent — a level that the central bank won’t consider fostering now — for much of the rest of that decade. “Maybe there was some subtle way that 4 percent inflation was undermining the economy, but people didn’t seem very worried about it,” he said. Smith, meanwhile, has compiled data showing that price acceleration and job growth tend to move in tandem.
Too much acceleration can be a dangerous thing, of course, especially from a higher base. But as the chart titled “Inflation Rate 1983-1994” shows, during the mid-1980s the rate remained at moderate or low levels for a number of years, then briefly crept up to about 6 percent at the end of the decade. The Fed was subsequently able to bring the inflation rate down quickly, and it has remained at lower levels ever since.
While the argument for higher inflation now seems out of the mainstream, a look back to the late 1990s, when Japan encountered a macroeconomic situation that many economists worry is broadly similar to the one America faces today, is instructive. Milton Friedman — the conservative economist and Nobel laureate who is generally credited with steering economic thinking away from Keynesian ideas, and who influentially argued that there are limits to what the government can do to boost employment — recommended a very similar course of action to that being promoted by Smith and others. At about the same time, Bernanke — then a Federal Reserve governor — publicly urged Japan’s central bank to set an explicit inflation target of 3 to 4 percent, so that it might bring prices back to the long-term trend.
Today, in his role as Fed chairman, Bernanke acknowledges that inflation has fallen too low, but he rejects calls for aggressive action. His argument rests in part on the claim that expectations about future inflation — which influence the current demand for money and the value of assets — are “well-anchored” (that is, stable). Data collected by the bank’s Cleveland branch, though, show that is not the case: since April, as the chart titled “Recent Inflation Rate Expectations” shows, expectations about future inflation have fallen consistently.
Elsewhere Bernanke has worried, as he did in Jackson Hole, that boosting inflation could cost the Fed credibility — that, in essence, the public will lose confidence in the bank’s inflation-fighting bona fides, and we will relive the experience of the 1970s. Sumner argues that this concern is ill-founded, because of technical and analytical advances in the ability to detect and correct any nascent hyper-inflationary trends. Even if there is some risk, Ball added, “that doesn’t seem a big enough worry relative to the certainty of the terrible human cost of unemployment staying at 10 percent.”
Why the Bernanke Fed has not followed the logic of Bernanke’s earlier insights — and why the particular lessons of the 1970s and early 1980s loom so much larger in its thinking than other concerns — remains a puzzle. It may be explained in part by an internal disagreement about whether the rise in unemployment is really driven primarily by a massive failure of demand, or by other, “structural” factors.
The term “structural unemployment” has gone in and out of vogue over the years, its precise meaning shifting with each intellectual cycle. In the current debate, it refers to what’s also known as “mismatch” — the idea that businesses actually do want to hire employees but can’t find any quality candidates, because too many workers have skills that are only useful to industries in which there is little demand (like housing construction), or are trapped in regions far away from the jobs (like Florida). The core piece of evidence for this claim, called the Beveridge curve, shows the correlation between job vacancies and unemployed workers. The relationship has generally been steady, but beginning in 2009 the numbers diverged, with the unemployment rate well above what the curve would predict.
The argument is significant because, if unemployment of nearly 10 percent is caused by “structural” factors — either a temporary mismatch between jobs and workers, or, as some critics worry, a long-term degradation in the skills of the American workforce — there’s not much that the Fed can do about it. “Most of the existing unemployment represents mismatch that is not readily amenable to monetary policy,” Narayana Kocherlakota, the president of the Minneapolis branch of the Federal Reserve, told an audience in Michigan in August, because “the Fed does not have a means to transform construction workers into manufacturing workers.” Other regional Fed presidents have offered different reasons for the bank to stand pat: that sluggish hiring and business investment is actually a result of regulatory uncertainty, or that by adjusting its policy to meet political demands, or pick up the slack for Congress, the Fed would compromise its independence. But the structural unemployment argument is the most direct challenge to the case for central bank action: the Fed can pump all the money it wants into the economy, but if American workers can’t produce the things that consumers want to buy, that money can’t be spent in ways that create jobs.