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I've always wondered...

Why is inflation necessary?

Mitchell Hartman Sep 12, 2019
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Kazuhiro Nogi/AFP/Getty Images

Geoffrey Dutton worries a fair amount about rising prices. He’s in his 70s, retired from the tech industry and living on a fixed income. He had a good question for us:

“Why must our dollars lose their value over time? The conventional wisdom seems to say that there has to be some inflation. Wouldn’t an economy without inflation make us all better off?”

Anyone who lived through the 1970s in the U.S. experienced runaway inflation that savaged the U.S. economy and contributed to the struggles of two presidents: Gerald Ford and Jimmy Carter.

Ford took office in 1974, as the Consumer Price Index spiked by more than 11%, which President Ford tried to fight with his WIN (Whip Inflation Now) campaign. Under President Carter, inflation soared from 6.5% in 1977 to peak at 13.5% in 1980.

Labor economist Michael Strain at the American Enterprise Institute said that scary images of hyper-inflation in history — from Europeans carting around worthless money in the Great Depression, to gas lines and soaring U.S. pump prices in the 1970s— make Americans fear any significant price rises today.

“We’re used to thinking of inflation as a problem, something we want less of,” said Strain. “But now, the concern among economists has done a pretty dramatic flip, to being concerned about too little inflation.”

Strain pointed out that the Federal Reserve has set an annual inflation target of 2.0%, which it’s struggled to meet. As of July 2019, the Fed’s preferred measure of inflation — Personal Consumption Expenditures (PCE) — is up 1.4% year-to-year, 1.6% excluding food and energy.

Economics professor Mark Kuperberg at Swarthmore College said that decades ago, “there was a view that zero inflation was the right number, and there are some fancy theoretical models that support that. But it’s a minority view among macroeconomists now.”

Why do economists and Federal Reserve governors think the U.S. economy needs inflation at all? One standard explanation is that if prices stop rising, consumers will hold back on spending, waiting to get a better deal. 

But economist Dean Baker, co-founder of the Center for Economic and Policy Research, doesn’t think consumers actually plan that way when faced with the prospect of stagnant or deflating prices.

“Suppose you’re going to buy a refrigerator, and we’ll just say it costs $1,000 — we’ll make it a really nice refrigerator,” said Baker. “And you say, ‘Wait a second, prices are falling 0.5% a year. So if I wait six months, then I could save $5.’ I don’t think that’s a very realistic story.”

Kuperberg pointed out that lack of inflation can create problems for consumers, because when prices fall, wages are likely to fall as well, since firms are earning less for what they sell.

“When you have deflation, people who have borrowed money have to pay back what was in the original loan, but it’s a lot harder to earn that money. So bankruptcies increase,” he said.

Both Baker and Kuperberg said the most compelling economic argument for inflation has to do with monetary policy and the Federal Reserve.

“Some amount of inflation — 2%, 3%, maybe 4% — turns out to be very beneficial because it gives the Federal Reserve more ability to boost the economy in a downturn,” said Baker.

To fight recession, the Fed cuts interest rates to lower the cost of borrowing money, in order to encourage businesses and consumers to spend and invest more.

Since interest rates are calculated in part based on the inflation rate, if inflation is near zero, the Fed doesn’t have much room to lower interest rates further. So a moderate level of inflation gives the Fed the maneuvering room it needs to try to jump-start economic growth

Kuperberg said inflation hawks have little reason to worry that the Fed’s efforts to generate a bit more inflation will spark hyper-inflation like we saw in the 1970s.

“It’s not the case that if the central bank is trying to push for a slightly higher inflation rate, it will get completely out of control, and all of a sudden we’ll have 12% inflation,” he said. “That is totally not happening.”

But even moderate inflation, like the U.S. economy is currently experiencing, isn’t good for everyone. People on a fixed income see their purchasing power slowly erode. And if wages don’t rise at least as much as prices, workers lose ground and become poorer over time, as well.

Tell us what you’ve always wondered about.

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