Why A Dash Of Inflation Doesn't HurtRobert Kuttner
Bob Dole, Senate Majority Leader Trent Lott and 18 other Republican senators are co-sponsors of an eccentric piece of legislation that ought to become an election issue. The bill, whose principal author is Senator Connie Mack (R-Fla.), is titled the Economic Growth & Price Stability Act. It would repeal the 1978 Humphrey-Hawkins Act, which charges the Federal Reserve with maintaining both low inflation and high employment. Instead, Congress would mandate a single goal of monetary policy: "price stability."
This directive would be unprecedented. The Fed's ability to tolerate a bit of inflation to combat recession would be undermined, putting the economy at risk of deflation and depression. The bill reflects several currents of conservative economic thinking. The oldest is Milton Friedman's "natural rate of unemployment." In this view, activist monetary policy cannot change the natural trajectory of the economy. So the Fed should not lean against the economic winds, even during recessions, but rather should target stable growth of the money supply and let business cycles right themselves. Even Alan Greenspan, no liberal, doesn't buy this view. Greenspan's Fed enacted several rate cuts during the last recession.
TRADE-OFF. More recently, theorists have argued that zero inflation is preferable to modest inflation (2% to 3%) on other grounds. Harvard economist Martin Feldstein contends that even slight inflation raises the effective tax rate on capital and thus depresses the incentive to invest. Feldstein's Harvard University colleague, Gregory N. Mankiw, argues that inflation distorts planning for retirement. People's retirement savings will be eroded by inflation, but today's workers don't appreciate the magnitude of that erosion, so they don't save enough. Other economists have long argued that inflation and the fear of inflation distort economic decisions, reduce efficiency, and raise capital costs. Zero inflation would eliminate all these distortions and lead to higher savings, investment, productivity, and growth.
In theory, it's a fine story. However, zero inflation would cause more problems than it would solve. It would worsen the trade-off between inflation and unemployment. According to Brookings Institution economist William T. Dickens, in a recent presentation to the Jerome Levy Economics Institute, an inflation rate of 3% yields a sustainable unemployment rate of 5.8%, while zero inflation produces a higher jobless rate of 7.5%.
The reason is what economists call nominal wage rigidity. Workers resist cuts in the nominal dollars they are paid, though they do tolerate real wage cuts caused by inflation. Thus, a little inflation allows labor markets to function more flexibly and lets employers take on more workers, who accept small real wage cuts extracted by inflation rather than by the boss. Moreover, according to Brookings' Dickens, countries with low productivity and high unemployment that have sought tight-money cures, such as Canada, have reaped only higher unemployment. Nations such as Germany and Japan, with low but not zero inflation, have been among the best performers.
"DEBT DEFLATION." A moderate amount of inflation, in effect, is a kind of economic lubricant. And contrary to the natural-rate doctrine, there is no evidence that low inflation inexorably mutates into high inflation. Moderate inflation was well-behaved during the 1950s. It rose because of the shocks of the Vietnam War and then OPEC, not because a small amount of inflation fed on itself. Likewise, in the 1990s, low inflation shows no sign of breaking out into high inflation.
If the Fed were required to target absolute price stability, it would be precluded from using monetary policy during economic downturns if the result were even 1% or 2% inflation. The country would be at risk of a "debt deflation," in which debtors find themselves paying off debts in dollars more expensive than the dollars they borrowed. In a general deflation, monetary policy is largely impotent since Treasury securities cannot be issued with negative interest rates. This is the old problem of "pushing on a string."
The sponsors of this bill wrote in a bit of wiggle room. Nowhere do they spell out the meaning of price stability (though the bill implies zero inflation). Rather, the Fed is directed to define price stability and to set a timetable for achieving it. But if the bill means what is says, it is dangerous economic policy. And if it allows the Fed to define price stability as, say, 3% inflation (current policy), the bill is meaningless. Either way, its sponsors are up to mischief.