To Inflate or Not to Inflate

The nomination of Janet Yellen to the chair of the FED seems to be as good an occasion as any to bring this blog back from the dead. No real comment on that other than it’s awesome, so let’s get back into some general monetary economics.

Following the Great Recession there has been a lot of talk about the adequacy of the monetary policy response in its aftermath. Particularly the issue of the zero-lower-bound, well-known to Japan but often treated as something akin to an exotic decease that would never concern countries such as the United States, has been hotly debated. One of the most common calls to try and avoid the issue in the future, or at least make it’s occurrence more unlikely, has been to increase the inflation rate targeted by central banks. In the case of the United States the talk is often about raising it from 2% to 4%, whereas Japan has stopped talking and finally moved to do something about its long-lasting problem by increasing its target from 1% to 2%. And for all it’s worth, it seems to have worked fairly well. The two opposing views on this issue usually range from some weird notions of the “danger of inflation”, of “unanchoring inflation expectations” and everyone dying (or something) on the one hand to an essential no-brainer with little down-side risk on the other hand.

There is not much to say about the first notion other than there seems to be no compelling reason that central banks would have a harder time stabilizing inflation at 4% than at 2%. Even the lowest threshold value found in studies regarding the level at which things start spiraling out of control is around 8% and 4% certainly seems far enough away. Also, fear of inflation in general is essentially the view held by Niall Ferguson, which alone is a pretty safe indication that it is almost certainly wrong. The second view, however, is much more interesting. Indeed, in a perfectly nominal world (i.e. one where everyone and their dog is protected from the effects of inflation), increasing the inflation target by 2 percentage points would seem like the closest thing to a free lunch one might find.

However, and even if it is often downplayed, it would not seem to be that the issue of what a permanently higher level of inflation does to an economy over a longer period of time is as trivial or well-understood as is often portrayed. At least from my review of the somewhat limited literature on the topic it does not seem to be the case that we have all that good of a grasp of what would actually happen. My list of possible channels through which (either directly or indirectly) a higher level of inflation could affect income and wealth distribution, for instance, is solid two pages long and probably more than just incomplete. It also includes a lot of ifs and buts’, necessary assumptions regarding the distribution of creditors and debtors within the society, the nature of government institutions, the nature of different types of contracts and the bargaining power distribution between e.g. workers/unions and companies, just to name a few examples. Changing any of those assumptions flips the entire outcome.

It also does not seem entirely certain to me whether the effects this inflation would have on income distribution and wealth distribution would tend to be pointed in the same direction. And most importantly, the time frame used to make such analysis is vital. In times where the higher level of inflation boosts output back to its potential through monetary stimulus this would seem to almost certainly lower both types of inequality as measured by conventional inequality measures. What happens to the middle class is another entirely different story. It is unlikely to be the case anytime soon that we can declare that the “central problem of depression-prevention has been solved” (as Robert Lucas infamously declared back in 2003), so there will probably be another occasion where we could very much use the higher level of initial inflation. Krugman is also essentially correct in claiming thatone of the dirty little secrets of economic analysis is that even though inflation is universally regarded as a terrible scourge, efforts to measure its costs come up with embarrassingly small numbers”, yet as far as I can tell Friedman’s finding that Inflation is always and everywhere a monetary phenomenon” is about as much as we can say with real certainty.

Overall, systematic changes in inequality are generally a long-run issue, and despite price stickiness and whatnot money remains essentially neutral in the long run for the levels of inflation we’re talking about. Further, inflation most likely impacts inequality mainly through its effect on output to begin with, and from this point of view there is little reason to believe there would be any difference at all between 2% and 4% inflation during normal times. Yet maybe the fact that we would like to increase the inflation rate target says more about the nature of the target itself than about its fairly arbitrary numerical value.

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4 thoughts on “To Inflate or Not to Inflate

  1. Actually, I can’t see how income redistribution should be affected by a higher inflation target at all.
    Of course, surprise inflation redistributes real wealth between creditors and debtors. But that’s not what we are talking about here, right? This is about raising the inflation target, which is meant to “anchor” inflation expectations around a higher rate. Once everyone (and their dog) expects 4% instead of 2%, creditors demand 2%-points more nominal interest which debtors should be willing to accept. As long as the real interest rate isn’t affected there’s no redistribution. But why should the real rate be affected?
    The only redistributive effect of higher anticipated inflation that I can see is this: Since inflation is a tax on cash holdings, it affects those people disproportionately who hold disproportionately large amounts of cash relative to their income. But given the small inflation rates we are talking about, I think it doesn’t matter.
    So I really would like to see that 2 pages long list.

  2. It is certainly true that unexpected and expected inflation have vastly different effects on the economy in general and inequality in particular. Yet the statement that if inflation is expected it has no impact at all on real interest rates is not exactly correct, even in a “perfect” economy. The concept is generally known as the Mundell-Tobin effect, and basically boils down to the fact that the level of inflation (due to nominal interest on cash, obviously, always being 0%) does have an effect on portfolio choices of the population, and through that affects the real interest rates.

    Also, market participant heterogeneity is important, and even if everyone expects the inflation, that does not mean everyone is in the same position to protect himself from its effects. As a quick suggestion, I would assume that, particularly in the presence of somewhat high unemployment, yet even if there is merely a difference in bargaining power between employers and employees due to institutional reasons, it might be quite possible for e.g. employers to expect all the inflation they want, and be spot on in doing so, yet might not be able to keep their real wages constant at the bargaining table.

    I cannot think of a story to tell at the moment, but in theory I do find it plausible that something similar might occur in financial markets, essentially boiling down to having multiple real interest rates in the economy, and certain parts of the population getting an upper hand through this mechanism. Sure, the effects of it all might be small, but they seem unnecessary – the main point of the post was, and I should have gotten into that earlier I guess (and also mention it explicitly) that an alternative target, particularly an NGDP level or growth target (I think I’ll get into why that difference matters in a couple of posts) seems vastly superior (at least on paper). We get the higher inflation we want when we need it, yet don’t have to deal with it when we don’t.

    I can’t upload anything here, but I’ll gladly send you the paper.

  3. Thanks for the hint with the Mundell-Tobin effect. I didn’t think of that.

    I am not convinced of the effect on bargaining positions. If workers have the bargaining power to get 2% higher nominal wages in the face of 2% inflation, why shouldn’t they have the bargaining power to get 4% in the face of 4% inflation? Is that some behavioral thing?

    Oh yes, I’d love to see the paper.

  4. Hmm…that is indeed something I seem to have missed – which is why I enjoy this blog so much, it forces me to think everything through thoroughly or be called on it, like you are doing. What matters is of course not really whether bargaining powers as such are unequal (as for some reason I assumed at first), but rather whether bargaining powers would permanently shift with a higher rate of inflation. From what I can tell, you are indeed correct in saying that that would be unlikely. It seems totally trivial when reading it now, but for some reason that did indeed slip my mind – thanks.

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