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Inflation Doesn't Hurt So Much, Does It?

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Instead of too much inflation, as so many hand-wringers were worrying about a few years ago, we now find ourselves with too little. Maybe it’s about time the Federal Reserve did something about it.

Just how little anyone expects prices to rise can be seen in inflation expectations, which have fallen off a cliff. Here is a graph of anticipated inflation, as measured by the 5-year Treasury inflation protected securities breakevens:

This is the financial market’s prediction for inflation rates during the next five years. The first thing to note is that expected inflation is now down below the level of late 2010, when the Fed announced its second round of bond-buying known as quantitative easing. The second thing to note is that expected inflation, at about 1.2 percent, is well below the Fed’s target of 2 percent. As for the economy, unemployment is down but wage growth is slow, and a drop in the stock market since the start of the new year may signal a weak patch ahead, as oil price declines clobber the once-booming shale industry.

Thus, it seems reasonable to expect that the Fed will do some kind of easing soon -- a delay in planned rate increases, or even another shot of QE.

These tools might be sufficient. But there might be better ways to generate more inflation.

The first would be for the Fed to stop paying interest on reserves. As things stand, when banks hold reserve accounts at the Fed -- which we normally call “cash” -- they get paid 0.25 percent annual interest. As insignificant as it might seem, that provides an incentive for banks to hold excess reserves rather than lend out their cash. Some economists, such as Harvard's Martin Feldstein, have argued that this incentive, although it looks small, is actually so big that it is holding down inflation.

In a recent paper, the University of Chicago’s John Cochrane put forth an even more intriguing hypothesis. When bank balance sheets are large, he argues, paying interest on reserves turns standard monetary policy on its head. No longer do lower interest rates cause higher inflation -- instead, Cochrane says, we enter a Neo-Fisherian world where promising to keep rates lower for longer actually reduces inflation. So if Cochrane is right, the policy of paying interest on reserves is interfering with forward guidance.

So eliminating interest on reserves is one thing the Fed might do in order to raise the inflation rate. Another idea is for the Fed to stop seeming so scared of moderate inflation.

The Fed’s official inflation target is 2 percent. That means that on average, inflation should be 2 percent -- sometimes lower, sometimes higher. But in recent years, it has started to look like that 2 percent is a ceiling. In other words, people may have started to believe that the Fed is fine with 1.2 percent inflation, but would view 2.2 percent inflation as dangerous. The Fed’s motivation to err on the downside of its stated target is natural, since the Fed tends to take the blame for high inflation, while low inflation or deflation is usually blamed on the economy instead.

In monetary policy, expectations matter a lot. No one knows the central bank’s true preferences and goals, so if the Fed allows the world to believe that 2 percent is the highest it will allow inflation to go, that could become a self-fulfilling prophecy. Even worse, as departing Federal Reserve Bank of Minnesota President Narayana Kocherlakota recently warned, allowing inflation to undershoot its target for an extended period of time might risk damaging the credibility of the Fed itself, which could hurt future monetary-policy efforts.

An obvious solution, therefore, would be to have Fed officials, including Chair Janet Yellen, make remarks explicitly stating that 3 percent inflation -- or even 4 percent -- wouldn't be the end of the world. This would fight against the “anchoring” of inflation expectations below 2 percent.

Now, some of you -- especially those of you who remember the 1970s -- may be shaking your heads and saying “But wait -- isn’t inflation bad?” And sure, too much inflation is definitely bad. But a small amount of inflation is necessary to grease the wheels of capitalism, since it allows companies to lower real prices and wages when necessary (since making outright price and wage cuts is often psychologically or politically difficult). When inflation dips too low, it transfers wealth from those who owe money -- companies and mortgage payers -- to those who hold bonds. That can slow economic activity by making it harder for people and companies to repay their debts.

So even though inflation has a bad name, we could use a little more of it. Perhaps the Fed should shed a little of its hawkish reputation.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net