Monday, October 31, 2011

Is High Inflation Good for Our Economy?

CNBC news clip on "Is High Inflation Good for Our Economy"

Krugman notes that  PR strategies are as helpful for Fed chairmen as for any other CEO. The recession in the early 1980's was induced by former Fed chairman Paul Volcker in order to fight inflation.  Volcker cleverly called his strategy "setting targets for monetary aggregates like M1 and M2" which borrowed credibility from the noted monetarist and Nobel laureate, Milton Friedman. This sounded better than calling the strategy "pushing the economy into a deep recession and keeping it there until inflation cried uncle" (quotes from Krugman's article).

NYT (10-30-2011) A Volcker Moment Indeed (Slightly Wonkish)

Krugman argues that if the Fed now wants to do the opposite, i.e. push the economy into inflation and keep it there until unemployment calls uncle, a good PR move would be to call the strategy "setting targets for nominal GDP" (again quote from Krugman's article).  Krugman then offers his support for some Bernanke induced inflation (above the usual 2% inflation rate target) to fight unemployment.

Many people disagree with Krugman. They argue that setting an inflation target higher than 2% is playing with fire.  The resulting inflation might be hard to control and the policy might undermine the credibility of  Fed as an inflation fighter.  People on this side of the argument often question whether pumping money into the economy would lower unemployment.  If the surge in the unemployment rate is structural (i.e. due to a mismatch between workers' skills and locations with companies' job openings),  and not cyclical (i.e. due to low general demand to buy stuff), then the Fed's actions would not accomplish much.

So what does the data say about how much of current unemployment is structural? It is still a work in progress. Nobel laureate Dale Mortenson recently gave a talk at Villanova University and provided new evidence suggesting that most of the spike in unemployment is cyclical rather than structural. See the ever informative Mankiw blog for more,

The Fed has a twin mandate - essentially (1) keep inflation low, and (2) keep unemployment low. If the economy is experiencing inflation below 2%, these goals are aligned.  Pumping more money into the economy will both bring inflation back to the desired level and help lower unemployment.

However, if inflation is at 2% (as it is now) these goals are in conflict. Supporting more inflation now is in effect putting more importance on the Fed's mandate to reduce unemployment.  It would help those underwater homeowners with fixed rate mortgages - which might create a more mobile workforce.

What do you think? Should the Fed consider say a 4% inflation target for the next two years?


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