Collective Conscious

Yes­ter­day Ben Bernanke was asked about cen­tral bank­ing infla­tion tar­get­ing dur­ing a media Q&A. Ques­tions of higher infla­tion tar­gets have been mak­ing the rounds for cen­tral bankers as inter­ested par­ties won­der, for exam­ple, whether higher infla­tion (and the asso­ci­ated higher inter­est rates) should be deployed in order to give the Fed more room to cut those rates dur­ing a downturn.

My own ratio­nale for increased infla­tion is more wide-​​reaching than the sug­ges­tion that it strengthen’s the Fed’s future pol­icy instru­ments. I believe that, fun­da­men­tally, an increased infla­tion tar­get will pro­vide much more of a finan­cial safety net in the gen­eral sense, as well as encour­ag­ing growth dur­ing eco­nomic expansions.

The first sug­ges­tion, that greater infla­tion is a bet­ter safety net, is pri­mar­ily con­cerned with find­ing more room to avoid the pos­si­bil­ity of defla­tion, which the US econ­omy made a dan­ger­ous brush with through­out 2009 and that has plagued post-​​bust Japan for nearly 20 years. Defla­tion is an infi­nitely more dan­ger­ous beast than over­in­fla­tion because the prob­lem is not sym­met­ri­cal — it does not sim­ply rep­re­sent a neg­a­tive inter­est rate. Defla­tion changes cash from being a lossy asset into one with real returns, since if tomorrow’s prices are lower, you can hold a dol­lar and buy more with it tomor­row. This encour­ages both con­sumers and investors to hold onto money rather than spend it, drag­ging down demand and caus­ing prices to fall even fur­ther, etc. A mod­er­ate level of per­ma­nent infla­tion helps to ward off this pos­si­bil­ity even if the money/​credit sup­ply con­tracts as it has.

Higher infla­tion also allows pric­ing imbal­ances to be more rapidly cor­rected by let­ting some prices stay con­stant rather than expe­ri­enc­ing a price decline in any given sec­tor. By avoid­ing micro-​​deflation in this way, infla­tion rein­tro­duces price flex­i­bil­ity into mar­kets where it has been his­tor­i­cally absent, such as labor mar­kets. If one is to make the argu­ment that over­paid labor­ers in, for exam­ple, Greece, are the cause of eco­nomic trou­bles, addi­tional infla­tion is one of the few ways to pay them less with­out ever hav­ing to broach a contract.

The other key argu­ment for increased infla­tion is the gen­eral invest­ment and growth expe­ri­ence of the broad econ­omy. When busi­ness­men real­ize that the Fed is going to clamp down on money/​credit growth to main­tain its infla­tion tar­get, even when com­pet­i­tive forces are dri­ving infla­tion upward, the abil­ity of entre­pre­neurs to finance new ven­tures falls as loans are expected to become rel­a­tively more expen­sive. This reduces expec­ta­tions both of profit and growth, which can in turn reduce actual profit and growth (the idea of ‘ani­mal spir­its’). A higher infla­tion tar­get allows a health­ier upswing to occur rather than sti­fling it, sat­is­fy­ing both entre­pre­neurs (who can invest more) and work­ers (who will have more work to do). This is where the term ‘refla­tion’ makes most sense, as prices are being allowed to adjust upward ratio­nally rather than being arti­fi­cially restricted. At some point, how­ever, the costs of the infla­tion can out­weigh the gains, and this is the level that must be care­fully determined.

On a side note, infla­tion also under­writes national bor­row­ing. It grad­u­ally deval­ues the debt which the gov­ern­ment has already accu­mu­lated, improv­ing its abil­ity to react to finan­cial pan­ics by decreas­ing its real lia­bil­i­ties. This in and of itself is no rea­son to pur­sue an infla­tion­ary pol­icy, because by this method infla­tion sim­ply becomes an alter­na­tive vehi­cle for tax­a­tion (and this is why the inde­pen­dence of the cen­tral bank is so impor­tant). At mod­er­ate lev­els, how­ever, the effect on this rela­tion­ship is likely to be smaller than the addi­tional safety and growth of industry.

Bernanke et al have main­tained that a 2% tar­get is an opti­mal level to achieve these goals. But judg­ing from expe­ri­ence, I believe that a more appro­pri­ate level would fall between the 4 or 5 per­cent mark. The increased flex­i­bil­ity that such a tar­get would afford our econ­omy in times both good and bad make a sen­si­ble case for the higher tar­get. The argu­ment that we “aren’t start­ing from scratch” on the infla­tion tar­get, and hence have even more rea­son to stay at the cur­rent level, sim­ply doesn’t resound with me. Instead, I’m more inclined to think that, for exactly that rea­son, we have found that those 2-​​percent the­o­ret­i­cal lev­els are sim­ply too low to give us the maneu­ver­ing room we need in an unsta­ble real econ­omy, and that rais­ing it would make a great deal of sense.

(Photo: kevin­doo­ley)