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Inflation: The Right Medicine
It’s not always good, but right now it is.


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James Pethokoukis

Inflation may be, as Milton Friedman put it, always and everywhere a monetary phenomenon. But high, economy-wide inflation isn’t always and everywhere a problem. Like right now, for instance. One anecdotal sign of this: Radio commercials hawking gold now say that Asian demand will drive gold prices higher, rather than urging investors to flee to the yellow metal as an inflation hedge.

The hard data tell the same story. In the twelve-month period that concluded at the end of March, consumer prices increased just 1.5 percent, while the core consumer price index, which strips out volatile energy and food components, rose 1.7 percent. Now, the conspiracy-minded will say that sharply rising food prices make liars of government statisticians — anyone going to the supermarket lately has noticed big price increases for items such as beef, pork, poultry, eggs, and milk. But Americans spend a smaller portion of their family budgets on food than citizens of any other advanced economy. And don’t blame the Federal Reserve for those grocery-aisle shocks. A record drought in California has thinned cattle herds and hurt harvests for a variety of fruits and veggies, while a deadly virus outbreak has reduced the hog population.

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Inflation generally remains quiescent. Many economists, foremost among them Federal Reserve chairwoman Janet Yellen, actually worry inflation is too low. Some on the right might find this concern strange. Those of a certain age recall the 1970s as an era of runaway inflation and terrible economic volatility. And isn’t inflation a kind of invisible hit on investors who have to pay taxes on nominal capital gains? Deflation, on the other hand, seems to increase consumer purchasing power. Would America be better off, for instance, if the price of data storage on a flash drive was the same today as a decade ago rather than a tiny fraction? Of course not.

But deflation can also be harmful. Bad deflation happens when prices fall because of an economic shock. Assets and inventories are liquidated. Consumers and business stop spending. And it’s not just the prices of goods and services that fall. The price of labor, otherwise known as wages, tumbles, too. And why spend money today when it will be worth a bit more tomorrow? That expectation can further depress demand, leading to a vicious circle of more price cuts and more liquidation.

And sometime boosting inflation is the right medicine, like after a terrible recession and financial crisis when an economy can’t quite find its footing. Raising prices via monetary stimulus would increase total spending in the economy, lower debt burdens, and more quickly allow the economy to return to its pre-crisis growth trajectory. American Enterprise Institute economist John Makin speculates in a recent paper than weak business investment during this recovery is due to “falling inflation and the threat of deflation that boosts the real costs of borrowing.”

So how to put inflation to work for the economic good? Rather than target inflation, the Fed should explicitly and publicly target the level of nominal spending in the economy, or nominal GDP. NGDP includes both real growth and an inflation component. Right now a 5 percent target means allowing 2.5 percent inflation if you assume real growth is also around 2.5 percent. At other times, say in a productivity boom, that 5 percent rate might be composed of 4 percent real growth and 1 percent inflation. For now, though, expectation of higher nominal growth and higher inflation would boost both consumer and business spending. And going forward, a more stable macroeconomic environment would boost growth by reducing business, investor, and consumer uncertainty.

Higher inflation isn’t always and everywhere the correct economic fix. But right now it is.

— James Pethokoukis, a columnist, blogs for the American Enterprise Institute.



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