The Mirage Of Zero Inflation

It looks good but could hurt growth

Thanks to Alan Greenspan's Federal Reserve, inflation is currently running below 3% on a year-to-year basis, a 30-year low. Yet some economists and policymakers want to go further and pursue the elusive target of zero inflation. Senate Republicans have been pushing legislation to change the Fed's official mandate from promoting high employment and stable prices to the single goal of achieving price stability.

The benefits of an inflation-free economy could be significant. Inflation breeds uncertainty, adds to borrowing costs, and hurts those living on fixed incomes. Since taxes bite into nominal rather than real investment income, it also distorts saving and investment.

But zero inflation, observe Brookings Institution economists George Akerlof, William Dickens, and George Perry in a new study, also embodies costs. And these, they find, could exact a heavy toll on U.S. economic performance that would far outweigh its vaunted gains.

The problem is not the temporary pain of moving to zero inflation. Rather, it's the way zero inflation would affect the ability of companies to lower labor costs when their business is poor. In a free-market economy with at least a modicum of inflation, companies doing badly can reduce their relative wage bills by giving low pay hikes, or none at all, even as those doing well dole out above-average increases. Under zero inflation, however, the room for such adjustments would be severely constrained.

As a result, companies needing to reduce their relative wages could only do so either by cutting paychecks (thus hurting morale) or making do with fewer workers. Yet evidence from labor contracts, industry data, and company and worker surveys indicates that employers almost never cut nominal wages--a reluctance apparent even during the Depression, when prices were falling.

Given that reluctance, the authors find that companies in an inflation-free economy would keep relative wages too high and employment too low, with large negative spillover effects on the overall economy. According to their econometric model, the costs of maintaining zero inflation would be a permanent drop of from 1% to 3% in employment--and a similar continuing loss in gross domestic product. "Complete price stability," they say, "should not be the Fed's goal."

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