Inflation: Could a little more be good for the economy?

James Mullarkey handles stacks of freshly made $20 bills at the Bureau of Engraving and Printing on July 22, 2011 in Washington, D.C. Would higher inflation be good?

We get inflation figures for August on Tuesday. Back in July, the Consumer Price Index was up just 0.2 percent. Economists expect inflation to have remained modest in August, with a 0.2 percent increase in CPI month-to-month, and a 1.7 percent increase year-to-year. Similar increases are expected for the core CPI, excluding more volatile food and energy prices. Producer prices rose in August by just 0.3 percent month-to-month, and are up 1.4 percent since August 2012.

All of these recent inflation measures fall below the Fed’s currently stated target of 2.0 percent annual inflation.

The inflation picture is part of the background to a much-anticipated meeting of the Federal Reserve’s Open Market Committee (FOMC) this week. Policymakers are expected to decide when they will begin 'tapering' their current round of quantitative easing, in which the Fed has been purchasing $85 billion/month in assets -- government bonds and mortgage-backed securities.

The debate among economists: should the Fed begin ratcheting down its monetary stimulus and let credit start to tighten? If not, could the economy eventually overheat, sparking runaway inflation?

It’s a scary prospect for some, who live with memories of speeches like this, by President Carter in 1978: “The most serious problem that our nation has is inflation. And it’s getting worse.” By the late 1970s, President Carter would face double-digit inflation, topping 14 percent in the volatile election year of 1980.

“You’ve still got the generation of economists who came of age in the 1970s, when inflation was a serious problem, who are still fighting that war,” says Bruce Bartlett. He served in senior White House and Treasury positions in the Ronald Reagan and George H.W. Bush Administrations.

Lately, in columns on the Economix blog at The New York Times, Bartlett has been criticizing what he calls “inflation-phobes,” including some top policymakers at the Federal Reserve.

“Many of these bank presidents are inflation hawks,” says Bartlett. “Not that they have prevented inflation from happening” -- he points out that inflation has been tame throughout the post-recession recovery, generally falling below the Fed’s own 2.0-percent annual target. “Rather, they have kept growth slower than it would otherwise be, by preventing the Fed from taking additional actions that would have increased economic growth, because, they keep arguing, we must always fight inflation first, and not worry about unemployment.”

And how could more inflation spur more growth?

Dean Baker at the progressive Center for Economic and Policy Research, also a self-described inflation dove, explains that businesses, anticipating higher prices in the future, would likely invest more now in plant, equipment, and labor.

“The logic here is that if a firm sees that it’s able to sell its products for more money in the future, it’ll be more willing to hire more workers today, and to pay more,” Baker explains. He says that wages generally keep pace with rising prices. He says that’s true even without strong labor unions negotiating inflation-indexed contracts (or at least, contracts with steadily rising wages), as we had during the 1970s.

And, Baker points out, modestly higher inflation (he advocates around 4 percent annually) could help young people and homeowners, by allowing them to pay back today’s debts in tomorrow’s dollars.

“Insofar as people have debt—mortgage debt, student debt—that debt becomes less of a burden as prices and wages rise,” Baker says.

“I think it’s a lousy idea,” is the reaction of John Cochrane, professor of finance at the University of Chicago’s Booth School of Business.

Cochrane argues that, even if the Fed wanted to drive prices higher, it has little leverage to do so at this point. He says the Fed has already set short-term interest rates at near-zero, and the Fed’s quantitative easing effort has had only limited impact.

Meanwhile, Cochrane argues that “inflation doves” have the growth equation wrong-way-round.

“A little more inflation is usually the sign of an economy this is recovering, but not necessarily the thing that helps the economy to recover,” says Cochrane. “You know, rich guys smoke cigars, but smoking cigars isn’t going to make you rich.”

And Cochrane says that once inflation does begin to increase, as the economy gradually improves, the Fed will fight it, as it is mandated to do, because a healthy economy depends on keeping prices and wages in check.

“The whole game that’s being prescribed here,” says Cochrane, “is that the Fed should promise now to have more inflation later, than it will want later, once the economy recovers.”

About the author

Mitchell Hartman is the senior reporter for Marketplace’s Entrepreneurship Desk and also covers employment.

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