Can Inflation Kickstart The Economy Without Killing It? (Part I)

Note: This is the FIRST of two posts on this question

In his latest New York Times Magazine column, Adam Davidson writes, "Like a defibrillator, inflation is a blunt tool that, used exceedingly sparingly, can sometimes save the patient."

To continue the discussion, we asked two economists — Edwin Truman of the Peterson Institute and Jeffrey Miron of Harvard and the Cato Institute — to answer the following question:

Would 5 percent inflation stimulate the economy or send it into a tailspin?

Edwin Truman's answer is below; To read Jeff Miron's answer, click here.

The answer to whether five percent inflation would stimulate the US economy or lead to ruin is not that simple. Temporarily higher inflation might be marginally helpful. Risks would be involved, but the economy would probably not go into a tailspin. On balance, however, unless done very carefully, the risks would outweigh the small potential rewards.

Five percent inflation, if it were expected to persist for only a few years, should have small positive effects on jobs and output. The principal channel would not be consumers rushing out to buy household appliances before their prices rose, however. An extra 2-3 percent of inflation per year would not be sufficient inducement.

The principal channels instead would be four others. First, prices would rise more rapidly than wages, which would encourage employers to expand employment and output. The average citizen might not be happy with this channel.

The average citizen, however, would be happier if one of the higher prices was the price of his or her home. With a fixed-rate mortgage, the real value of the debt would go down even if the price of the house did not rise. The boost to household wealth should lead to more spending. Third, temporarily higher inflation would have similar effects on the balance sheets of the federal, state, and local governments as tax revenues rose, the real value of their debt declined, and nominal GDP rose, improving government debt ratios. This would lead to fewer government expenditure cuts and/or tax rate increases. Finally, temporarily higher inflation would lower the real cost of borrowing, which should stimulate business and household investment.

So far, so good. But what are the risks? They are three.

First is the risk of failure. The economics textbooks say that the Federal Reserve raises the inflation rate by creating more money. It is not as simple as that. The Federal Reserve creates money by lowering interest rates and expanding its balance sheet, which it has done. Nominal short-term interest rates are close to zero, nominal long-term rates are at historic lows, and the Federal Reserve's balance sheet is three times what it was in December 2007. Inflation has averaged just over 2 percent since then.

The second risk is too much success. As we learned from the 1970s, inflation rates in advanced economies at 5 percent or more on average increase volatility and depress growth over the longer term. Again, the longer term is not the main concern right now, but if the Federal Reserve were unable to get the inflation genie back into the bottle, it would become a concern.

The biggest risk is that higher inflation would undermine confidence in US macroeconomic policies here and abroad. The result might be higher nominal and real interest rates, cutbacks in business and household spending, dumping of US dollar assets, and a run on the dollar. A lower dollar might not be all bad, because it would stimulate exports and discourage imports, but the process could get out hand.

Some of these risks might be managed if the Federal Reserve announced in advance a novel policy designed to achieve a price level 15 percent higher in three years after which it would revert to its current objective of inflation of around 2 percent per year. But that is a topic for another commentary.

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