A Bad Inflation Idea That Won't Die

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If there was any consolation in the Sunday New York Times front-page article, "In Fed and Out, Many Now Think Inflation Helps," it was that the "in Fed" names were few and far between. Yes, Federal Reserve Vice Chairman Janet Yellen, who was nominated to replace Ben Bernanke in January, is mentioned in connection with the idea that "a little inflation is particularly valuable when the economy is weak." But that was it.

Until now, targeting higher inflation as a cure for weak growth hasn't gained traction among the central bank set. I doubt that will change soon, even with the leadership rotation. Why? Because the Fed moves at a glacial pace. It took 17 years to evolve from announcing a change in the federal funds rate to holding a news conference to explain policy decisions. Given that the Fed first formalized its 2 percent inflation target last December, I doubt it's going to double or triple it anytime soon as some suggest.

An assortment of academics have been pushing the idea of higher inflation since 2008. Harvard's Ken Rogoff advocates "a sustained burst of higher inflation." What's sustained? What's moderate? And why should we think that the central bank can achieve that objective without letting inflation get out of control? Because policy makers suddenly announce they are reverting to a 2 percent target?

That's just one of the many problems with the idea that raisinginflation expectations will lower real short-term rates, encourage consumers and businesses to spend more today, and boost economic growth. Consumers' inflation expectations have barely budged over the last two decades from 3 percent, according to the University of Michigan's monthly survey of consumers. That's true for a one-year and a five- to 10-year time horizon. Clearly the public isn't paying attention to the Fed's announced 2 percent inflation target or the 1.2 percent current annualized pace.

Inflation advocates say a little more inflation would boost corporate profits, increase wages and ease the debt burden for private and public sectors. Gosh, if rising prices can perform such feats, you have to wonder why central bankers have spent decades striving for stable prices, often to the detriment of economic growth!

There is no guarantee that wages will keep pace with prices. The Times's Binyamin Appelbaum says as much in a blog post yesterday, responding to what he says were "skeptical responses" from readers to his Sunday article.

Skepticism is warranted, especially when it comes to something that sounds so good on paper but is unlikely to work in practice. A central bank may say it wants 4 percent inflation for only two years, but bond buyers may demand added protection. Nominal long-term yields would probably rise to incorporate higher inflation expectations, leaving real long-term rates unchanged. It's real rates that drive the economy (at least that's what we're taught).

I could go on and talk about the issue of central bank credibility, which was hard won and could be easily sacrificed for questionable short-term benefits. But I won't. The next recurrent bad idea is probably just around the corner, waiting for me to nip it in the bud.

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