A Little Inflation Can Be a Wonderful Thing


Should the Fed tolerate higher inflation as a way of tackling our economic slump? Paul Volcker, who’s most famous for throwing the economy into a massive recession in order to fight inflation in the 70s, thinks this would be a terrible idea. Karl Smith disagrees:

My point is not simply — as seems to be Ken Rogoff’s — that a jolt of inflation inflation would be good for the economy right now — though I believe it would be.

My case is that 2% inflation is a fundamentally bad idea. I argue that 4% inflation is not merely “OK” it is preferable. It is preferable because even in normal times it produces higher nominal interest rates. Higher nominal interest rates in turn give the Fed more leverage under traditional monetary policy.

As it happens, this has long been my view too. Volcker’s response, I suspect, would be strong skepticism that 4% inflation can be maintained. Once it gets that high, there’s simply too much temptation to let it get ever higher, and you quickly end up in an inflationary spiral like the one he had to deal with.

Maybe. But I think it’s worth keeping in mind that the inflation of the 70s wasn’t inevitable. It was the result of oil shocks and uniquely poor Fed policy. Arthur Burns could have kept the inflationary genie in the bottle if he’d had the spine to do it, but he didn’t. He was too much of a political hack. And a deliberately chosen one, too: Richard Nixon blamed his defeat in 1960 on tight money engineered by the Fed, so when he had an opportunity to appoint a Fed chairman of his own he made sure to appoint one who would provide him with the easy money policies that would keep the economy roaring. Burns may have had some qualms about this from time to time, but basically he complied.

I suppose Volcker would scoff at this, but times have changed. The Fed has more institutional independence now than it used to, and its mandate to control inflation, though weaker de jure, is stronger de facto. What’s more, to the extent that strong unions contributed to a wage-price spiral (about which the evidence is hazy), they no longer do. So the fundamentals are almost all in favor of controlling inflation these days.

But in the spirit of compromise, here’s mine. In practice, the Fed doesn’t target 2% inflation. If they did, it would sometimes be a bit below that and sometimes a bit above. In practice, they treat 2% as a ceiling, which leads to inflation that’s lately been in the neighborhood of 1-2%. So why not adopt a target of 4%, but explicitly make it a ceiling? That would actually be easier to maintain (no more arguing about whether inflation has been above the target for “too long”) and would probably produce actual inflation in the 3-4% range. The genie would stay in the bottle and monetary policy would have more bite.

Now all we have to do is get Ben Bernanke to agree. Who wants to be the one to pick up the phone and sell him on this?

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