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2% Inflation and the Fed
Taming the Deflation Dragon
Global Inflation – It takes 150 to Tango

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One of the key issues for business and government planners is how fast inflationary expectations adjust to current conditions. Sometimes inflationary expectations are like a 2,000 ton object – that is, they do not move easily. If the inflation rate has hovered around 3% for quite a while, it is difficult to get people to believe that future inflation will not equal around 3%. But there are other time periods when people are much more sensitive and shift their inflation expectations, seemingly at the drop of a hat. Just a rumor of rising AD or mention of oil crises and the result could be an increase in inflation expectations. The trick is to know which kind of regime dominates today. Why would you care? Because inflationary expectations affect behavior that is aimed at taking advantage of the higher inflation – or attempts to reduce its negative impacts. Consider all the possible reactions to higher expected inflation. Planners who best anticipate when and to what extent inflationary expectations change will be better at know how to deal with these kinds of reactions.

  • Buy now, instead of later when the prices will be higher
  • Sell less now – sell more later when prices are higher
  • Ask for a wage increase now
  • Supplier asks for a price increase now
  • Lender wants a higher nominal interest rate
  • Sell stocks now (if you think that inflation will be bad for stock prices later)

The following chart shows two survey-based measures of inflation expectations. These are often cited by the business press. For updates to this information use the following link: http://research.stlouisfed.org/publications/mt/page8.pdf

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These measures come from the University of Michigan and the Philadelphia Federal Reserve Bank. These are not official government statistics. One thing to notice is that the expectations are not as volatile as the actual inflation rate. This suggests that expectations move a little slower than actual inflation and may underscore the market’s own ability to differentiate between macro inflation and relative price changes. If the latter are temporary then they would not be used to predict future inflation. Notice also how much actual inflation fell in the 1997 to 1999 time period.  Inflationary expectations hardly budged. It is a good thing because you can see that inflation snapped back quickly after that. If you had been “fooled” by the actual inflation into accepting a move lower wage increase, then you might have been very sorry by 2001.  As for recent years, the charts show great disparity of expectations of year ahead inflation as measured by the University of Michigan and the Philadelphia Fed.  Michigan shows the inflation rate rises to the 4-5% range in 2012 while Philly has inflation staying at around 2%.

Why do we care about inflation and deflation?

Perhaps it seems obvious that high inflation would not be good for a country. But it isn’t so obvious or more countries would have very low inflation and many would have zero inflation rates. If inflation is so bad, then why don’t we eliminate it? The answer is that we believe there is a cost to eliminating inflation just like there is a cost of reducing the incidence of accidents and disease. Accidents, disease, and inflation are not good things, but the cost of getting rid of them completely does not seem to be worth the effort. So we look for an “optimal” degree of reduction, where this optimal improvement reflects the fact that reduction may cause other problems.

What is so bad about inflation?

Before we discuss these costs of getting rid of inflation, let’s look at the problems it causes.

The backgrounder on inflation and price stability (see link below) lists some of these problems.

Backgrounder on Inflation and Price Stability, Bank of Canada (2 pages): http://www.bus.indiana.edu/davidso/corefall04/S12bDisinflation%20and%20Deflation%20-%20Bank%20of%20Canada%20Backgrounders.htm

“High and unstable inflation undermines the economy’s ability to generate long-lasting growth and job creation.” Recall in the AS note how important the supply-side is to long-term growth. Recall also that much of the long-term growth is owed to business investment in plant, equipment, knowledge, and technology. High and unstable inflation can detract from the confidence that is needed for planners to risk their capital. This amounts to inflation adding a permanent risk margin to real interest rates – making them higher than necessary for long periods of time.

Very high inflation – as in hyperinflation – is even worse for a country. This is because the monetary unit breaks down. There were jokes in Germany during the hyperinflation that if one left a basket of money on their doorstep for a minute, when they returned the money would still be there but the basket would be gone. Money was losing value so rapidly that people would try to turn it as quickly as possible into goods. Why? Because goods prices were rising and goods were going to be worth more – not less – in the future. This kind of barter world is very wasteful and time-consuming. People spend too much of their time figuring out how to “beat the inflation” and not enough time doing their ordinary work and production.

“It creates uncertainty for consumers and investors and can lead to painful cycles of economic boom and bust….” This is a short-term story about the negative effects of highly variable inflation. You know that the real interest rate is very important for investment and saving decisions. If inflation is rising faster than expected, then real interest rates tend to fall and cause too much investment and spending – and too little saving. This leads to a boom. If inflation is falling relative to expectations, then the opposite happens and a bust occurs.

“High inflation erodes the value of incomes and saving”.  This cuts two ways. High inflation does not necessarily hurt the incomes or wealth of people who are “indexed”. Most of us try to make sure that our wages keep up with inflation. Most of us try to make sure that we buy assets whose returns at least keep up with inflation. In the U.S., social security benefits are adjusted each year to help the elderly keep up with inflation.  But not all of us are excellent at indexing and there are many people with relatively fixed incomes who are not well-indexed at all. Thus inflation can hurt the buying power of many people.

Is there nothing good about inflation?

On the positive side, there is some belief that a little bit of inflation is not a bad thing. So long as people do not think it is going to get out of control, a little bit of inflation is often considered to be a good sign about the future. To the firm, a little bit of inflation implies the possibility of higher prices and profits in the future. To the worker, a little bit of inflation may imply rising wages in the future. It gives people something to look forward to. A close reading of these last points suggests that they are based more on psychology than economics. If the firm expects higher prices in the future, it probably ought to expect higher costs as well. If the worker expects higher wages, then he or she probably knows this means higher future prices as well. So this story is not based on good economics – but it is one often told and deserves to be listed here.

Also on the positive side is the idea that zero inflation is too close to deflation. That is, once you get to zero, you are very close to a negative number. This fear of deflation explains why some people would rather see inflation above the zero mark. But is deflation really so bad? The following reading (see link below) by Tao Wu explains some issues about deflation. Of interest is that deflation may be good or bad for a country – and much depends on the cause of the deflation. U.S. political leaders were worried about deflation in 2003. Japan had experienced deflation during much of the late 1990s. The deflation worry usually stems from times when AD is very low and leads to declining prices. In Japan there seemed to be a loss of confidence that kept both business firms and households from buying. Deflation in Japan was associated with weak spending and weak real GDP. The author points out, however, that sometimes deflation can be the result of very positive supply-side factors like rising productivity. If that is the case then lower prices may be reflecting a very positive trend. That was not the situation in Japan though it might have had something to do with low inflation in the U.S. after 2000. Wu’s main point is that not all deflations are bad and therefore countries should not always prefer inflation above the zero line. Additionally, deflation in a world of non-negative nominal interest rates raises the real interest rate. This would have a negative impact on borrowers. While lenders might enjoy the higher real interest rates they would likely find very low demand for loans.

Understanding Deflation (3 pages), FRBSF Economic Letter, April 2, 2004-05-05 http://www.bus.indiana.edu/davidso/corefall04/S12Wudeflationf04.pdf

 

What is the perfect inflation rate for a country?

What is a little bit of inflation? Is there an ideal inflation rate? The answer is that it varies from country to country and from time to time. Economists generally agree that a lower inflation rate is better than a higher one. If a country has 10% or 98% inflation, most economists would recommend a reduction. The disagreement with this point starts occurring when the inflation rate gets below 5%. And here is where the cost/benefit discussion begins. To fully understand this discussion, we have to focus on the Phillips Curve analysis. Before we turn to the Phillips Curve we introduce some basic employment and unemployment concepts.