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Overcoming Our Inordinate Fear of Inflation

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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Here’s a question: Why do we care so much about preventing inflation?

When I put this query to baby boomers, they tell me that if I had lived through the inflation of the 1970s and early 1980s, I would understand. But this was also a time of slow growth, deep recessions and terrible asset returns. Inflation was hardly the only problem the U.S. economy was facing. So why does it stand out so strongly in our collective memory?

The harm of inflation cited in economics textbooks seems laughably unimportant. For example, inflation generates so-called shoe-leather costs -- a term for the hassle of moving money from one’s brokerage or savings account to one’s checking account. This hassle is larger when prices change a lot, since you have to put spending cash in your wallet more often. But in the age of digital-account management, this cost is nonexistent. The same is true of so-called menu costs, a name for the hassle of companies changing their posted prices. In the modern world, these things just don’t matter that much. A more sophisticated argument against inflation is that when companies want to change their prices but for some reason can’t, inflation distorts prices from what they should be, which decreases economic efficiency.

Economists have tried to measure these costs, and found that they’re just as small as we might expect. In 1981, and again in 2000, University of Chicago economics professor Robert Lucas -- sometimes cited as the father of modern macroeconomics -- investigated the costs of inflation. Lucas’s chosen model told him that inflation doesn’t put much of a dent in human welfare -- according to his 2000 paper, 10 percentage points of inflation is only about as harmful as a 1 percent reduction in gross domestic product. In other words, according to Lucas, even a mild recession is worse for people than the inflation of the 1970s.

Lucas’s model didn’t take into account the menu costs mentioned above. But economists Ariel Burnstein and Christian Hellwig looked at those in 2008, using data on how often companies change their prices. They find that, as one might expect, inflation has almost no perceptible impact on productivity -- and hence, on human well-being.

So the typical arguments for why inflation is bad don’t stand up. A better argument is that when prices rise fast, they also tend to be more volatile -- high inflation equals uncertain inflation. If inflation is predictable, lenders and borrowers can build it into their financing deals; nominal interest rates simply rise to take into account the shrinking value of money. Workers can ask for cost-of-living increases in their paychecks, effectively indexing wages to inflation. And businesses can build inflation into their investment plans. But when inflation bounces around from month to month, it’s harder to plan for the future. That makes financing, investing, hiring and any decision that involves forward-looking planning much more of a gamble. Naturally, that will tend to hurt economic growth.

Although the historical correlation between inflation and inflation uncertainty is well-documented, that doesn’t mean the one causes the other. If the Federal Reserve had a 4 percent inflation target, and managed to hit that target every year -- thus eliminating uncertainty -- we wouldn’t really be any worse off than if it hit its current 2 percent target.

So what does this imply about Fed policy? A lot, actually. The Fed’s so-called dual mandate, as laid out by Congress, is “to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” But that says nothing about the relative weights that the Fed should put on maximum employment versus stable prices. The central bank is perfectly free to worry more about one than the other.

Many people seem to think that inflation and recession are equal, symmetric dangers. This is implicit in the idea of nominal GDP (NGDP) targeting, which is promoted by economists like Scott Sumner at George Mason University’s Mercatus Institute. Since NGDP growth is just the sum of real GDP growth and inflation, Sumner’s policy implies that one percentage point of higher inflation is in some sense just as bad as a one-point reduction in growth. But in reality, a loss of one percentage point of GDP probably is many times worse than a 1 percent rise in inflation.

But economic research says that this probably isn’t the best approach for the Fed. As long as inflation can be kept from fluctuating wildly, or from spiraling upward into uncontrollable hyperinflation, the big worry should be about real growth. That means that the Fed probably shouldn’t be afraid of a higher inflation target, if that meant getting more people back into the ranks of the employed.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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Noah Smith at

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