The Wall Street Journal, in an article by Jon Hilsenrath, reports today (December 27, 2011) that recent reductions in the rate of inflation improve the chances that the Fed will decide to ease monetary policy.
U.S. inflation is slowing after a surge early in the year.
Some surge. From about 1.5% to 4% in the CPI and from about 1.5% to 3% in the PCE index. The GDP deflator barely moved staying roughly at 2.5%.
This is good news for Americans, as it means the money in their pockets goes further.
Well not quite, because inflation is still running above zero. But let’s not quibble about arithmetic. The real problem with that sentence is the unstated assumption that the number of dollars people have in their pockets has nothing to do with how much inflation there is. I do not expect Mr. Hilsenrath to accept my theoretical position that, under current conditions, inflation would contribute to a speedup in the rate of growth in real income, but it is inexcusable to ignore the truism that rising prices necessarily put more dollars in people’s pockets and simultaneously assert, as if it were a truism, that rising prices reduce real income.
It also is welcome at the Federal Reserve, which has been counting on an inflation slowdown. It gives the Fed some maneuvering room in 2012 if central-bank officials want to take steps to bolster economic growth.
Well now, we are switching theories, aren’t we? According to that assessment of the Fed’s options, falling inflation means that the Fed could ease monetary policy, thereby helping the economy grow more rapidly than it is now growing. How, one wonders, could the Fed do that? Um, maybe by preventing the rate of inflation from falling even faster? In other words, maybe inflation would drop down to zero or even to a negative rate, i.e., deflation. Don’t want that. But if falling inflation is good news, then, really, why not let inflation keep falling? In fact, why not go for deflation? How does falling inflation turn suddenly from being good to being bad?
The answer is that whether inflation is good or bad depends on the circumstances. Sometimes inflation can be too high; sometimes it can be too low. But we are operating under a monetary regime in which the rate of inflation is always supposed to be 2% or a bit lower. Anything above is too high; anything below is too low. There is just one problem: there is no single rate of inflation that is optimal under all circumstances. And the corollary of the idea that there is a unique optimal rate of inflation — the notion that the only concern of monetary policy is to keep the rate of inflation at that target rate, regardless of what is happening to the economy in general is not, as far as I can tell, grounded either in economic theory or in economic history. And please spare me any comparisons to the stagflation of the 1970s, which resulted from two severe supply shocks within five years sandwiched by two periods of rapid monetary expansion aimed at reducing unemployment below any reasonable estimate of what the natural rate of unemployment would have been at the time.