Surprise! Inflation Is Falling

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.

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20 Responses to “Surprise! Inflation Is Falling”


  1. 1 Frank Restly December 27, 2011 at 1:49 am

    “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.”

    Please check your facts before rattling off nonsense. The monetary expansion of the 1970’s was not an attempt to reduce the rate of unemployment. It was an attempt to increase the labor force participation rate.

    First natural rate of unemployment (Congressional Budget Office):

    http://research.stlouisfed.org/fred2/series/NROU

    Next unemployment rate (Bureau of Labor Statistics)

    http://research.stlouisfed.org/fred2/series/UNRATE

    Finally labor force participation rate (Bureau of Labor Statistics)

    http://research.stlouisfed.org/fred2/series/CIVPART

  2. 2 foosion December 27, 2011 at 3:13 am

    >>This is good news for Americans, as it means the money in their pockets goes further.>>

    This is an incredibly common thought. People believe that any compensation increases are due to their own merit, while price increases are an exogenous process that robs them of their money. It’s a very rare person who sees the ties that underlie the economy, employment, wage levels and price levels.

    Simplistic thinking (that could be summarized on a bumper sticker) wins in our society.

  3. 3 Floccina December 27, 2011 at 7:02 am

    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.

    Doesn’t it have more to do with the delta? That is too rapid a deceleration in inflation can cause unemployment and too much/too long acceleration can cause future problems. That is assuming no supply shocks.

  4. 4 Invisible Backhand December 27, 2011 at 7:39 am

    But, but, tripling the money supply must cause hyperinflation! Reality must be wrong!

  5. 5 Luis H Arroyo December 27, 2011 at 10:58 am

    David, good post, I agree completely -as you can imagine. but I think the problem is not the very low level of inflation: it is the lower level of yields in the world, perhaps a herald of a big contraction.

  6. 6 Benjamin Cole December 29, 2011 at 7:04 pm

    Excellent blogging. Obviously, right now we need to concentrate on economic growth, not dinky rates of inflation. Bernanke should declare 2012 the “year of robust economic expansion.”

    in general, why is it okay for the Fed to announce they will kill inflation, but not for them to say they will goose growth?

  7. 7 David Glasner December 30, 2011 at 8:38 am

    Frank, How about toning it down a bit, okay? The data you refer to have no bearing at all on what was motivating monetary expansion in the 1970s. Labor force participation was increasingly secularly as a result of demographic trends, monetary policy was aimed at accelerating recovery from recessions and improving the prospects for incumbent success in the 1972 and 1980 Presidential elections. That’s not really a controversial proposition.

    foosion, Well isn’t the blogosphere supposed to fix that?

    Floccina, The delta is probably important because a sudden large change in inflation is unlikely to be anticipated, thus having large effects on real not just nominal variables.

    Invisible Backhand, I’m sure that Plato, wherever he is now, must be nodding approvingly.

    Luis, It is always the relationship between inflation and expected yields that matters for macroeconomic performance, not one or the other in isolation.

    Benjamin, I think the fear is (based on some unfortunate experience in the 1960s and 1970s) that if the Fed tries to increase growth it will not know when to stop and generate inflation, when inflation can no longer positively affect growth. There is a sense in which the Fed is playing with fire when it prints money to increase growth, but in a situation like the one we are in now, it is irresponsible not to take a small risk that promises a big return in economic growth and reduced unemployment. But we shouldn’t lose sight of the downside risk either.

  8. 8 pilkingtonphil December 31, 2011 at 1:16 pm

    “…but it is inexcusable to ignore the truism that rising prices necessarily put more dollars in people’s pockets and simultaneously assert…”

    I don’t see the ‘truism’ at all. There are plenty of ways for inflation to occur without expanded aggregate demand. For example: any sort of supply-side inflation.

    There’s also the (implicit) question of speculation driving up commodity prices that are then fed into the rest of the economy. Are these really because people have more money in their pockets? If so what ‘people’? ‘We the people’? Or speculators who have more money in their pockets because they have less places to invest.

    Of course, I agree with the overarching point regarding inflation (although I strongly disagree with what appear to be market monetarist ideas). But we have to be very careful not to always assume that inflation is demand-pull. The media constantly make this assumption and the truth of the matter is that it often is not.

  9. 9 Frank Restly December 31, 2011 at 6:08 pm

    David,

    “And please spare me… 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.”

    I would not call this a low tone, even tempered analysis.

    “The data you refer to have no bearing at all on what was motivating monetary expansion in the 1970s.”

    Huh??? You brought it up. I provided a graph of the civilian participation rate, the natural rate of unemployment, and the unemployment rate and you say that none of this of data has any bearing on what was motivating monetary expansion in the 1970’s?

    The fact of the matter is that the monetary and fiscal expansion of the late 1960’s and 1970’s was directly aimed at putting more people to work. The success of those policies did not appear in the published “unemployment rate” because the U. S. workforce was growing faster than the number of jobs available. Hence it is better to look at the labor force participation rate or if you prefer the employment to population ratio:

    http://research.stlouisfed.org/fred2/series/EMRATIO

    Some of the backslide from the 2000 peak (64%) is demographics, but a lot of it just plain bad policy.

  10. 10 David Glasner December 31, 2011 at 8:35 pm

    pilkingtonphil, You are right that I was not explicitly addressing the possibility of supply-side inflation. However, my implicitly comparing a supply-side inflation to a benchmark in which monetary policy was counteracting the supply-side inflation to keep prices from rising. You speculation case may be just a particular instance of a supply-side inflation or it may be a case in which speculators are anticipating a future monetary policy that will cause inflation. So it does get complicated. As for the media, I am old enough to remember when it was taken for granted that inflation was caused by increasing prices of steel, oil, or wages. All inflation was cost-push. All in all, I think it’s a sign of progress that we are where we are. But we have a long way to go.

  11. 11 David Glasner December 31, 2011 at 9:27 pm

    Frank, You said:

    David,

    “‘And please spare me… 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.’

    I would not call this a low tone, even tempered analysis.”

    This was in reply to my request to you to tone it down a bit after you wrote the following in reply to the passage from my original post that you quoted.

    “Please check your facts before rattling off nonsense.”

    I apologize for failing to make myself clear to you when I responded to your reply. What I should have said instead of asking you “to tone it down” is:

    Stop making insulting and personally obnoxious remarks when making comments to me or to anyone else on this blog.

    And that was not the first time that you have used insulting and obnoxious language in responding to me. So if you want to continue commenting on this blog, and I encourage you to do so, please show some minimal courtesy in the future. Otherwise, find another blog to make your comments on.

    Concerning the substantive point that you are arguing with me about, obviously the objective of monetary and fiscal expansion was to increase employment which could be accomplished by reducing the unemployment rate or by increasing the participation rate. However, the unemployment rate is cyclically more variable than the participation rate, so that would be a more likely focus of monetary policy than the participation rate, though both were probably being affected. But the increase in the participation rate in the late 1960s and the 1970s was largely driven by baby boomers and women entering the work force for the first time not by cyclical factors.

  12. 12 pilkingtonphil January 2, 2012 at 6:55 am

    David,

    I think we have to be careful here. What I’m implying is that speculation may be driving much of the current inflation we’re seeing. And if this is true the monetary policy that the Federal Reserve has adopted may be exacerbating this.

    The QE programs took even moderately yielding assets out of the banking system and sent interest rates to the floor. This, coupled with the fall-off in profitable investments due to the stagnant real economy (and let’s not even talk about the stock market), makes it very difficult for investors to achieve decent yields. This makes speculation very attractive (just look at gold and silver for the most obvious example — has demand for them really risen due to fundamentals or is speculation in these markets keeping yields up for investors that have nowhere else to go?).

    Now, if we pursue what I believe you are implicitly advocating — that is, targeting negative real interest rates — you will only worsen this situation.

    In short, I believe that your lack of specificity regarding inflation has much wider implications as it blinds you from the real effects generating inflation will have (if the Fed can indeed generate inflation in this environment, which I believe they cannot beyond commodity price inflation). Personally, I think that targeting negative real interest rates will just sap more aggregate demand out of the economy by reducing real wages (which are already falling). This will simply exacerbate current problems.

    Monetary policy has failed and, to be frank, these calls for ever more ‘innovative’ monetary policy appear to me to be the death throes of a failed economic paradigm mutating in its last moments of life.

  13. 13 David Glasner January 3, 2012 at 1:18 pm

    pilkingtonphil, Thanks for sharing your perspective. I am not advocating targeting negative real interest rates. There is no mechanism for doing so, because real interest rates (ex ante) are not under the control of any policy maker. It is my claim that real interest rates are now negative and that at least for a short time, real interest rates might have to fall further before profit expectations are improved enough to bring them back up again. That’s what happened in the fall of 2010 after QE2 was initiated. Nominal rates fell for a short time and so did real interest rates, but as profit expectations and stock prices rose, real interest rate rose from negative to positive territory. Unfortunately supply shocks helped drive up energy prices and reduce economic activity early in 2011 and the promising start of QE2 did not materialize. Our best hope for recovery went down the tubes.

  14. 14 pilkingtonphil January 3, 2012 at 1:34 pm

    Hmmm… fancy that. I got a strong ‘market monetarist’ vibe off this blog. But I was quite wrong. Yes, I agree. The Fed has no mechanism.

    Where we disagree is energy prices etc. I think these were driven BY QE — not in spite of it. Here’s why I disagree:

    (1) Profit expectations in the current environment are different to what they are in non-deflationary environments. These days the ‘confidence fairy’ doesn’t come to visit whenever Bernanke raises his eyes to the skies. Instead businesses are looking at their bottom line and seeing that, fairy or no, there is insufficient aggregate demand on a huge scale.

    (2) Monetary policy cannot stimulate aggregate demand on the borrowing side because — well, because we’re “all borrowed out”. Private sector debt levels reached a plateau in 2008. They can go no further. Now they are starting to deflate as people delever — this produces a classic debt deflation.

    (3) Now, here’s where I reckon the speculation in commodities comes in. The financial sector can no longer inflate bubbles in the stock market and the real economy (housing sector). The exact same thing happened in Japan after the twin bubbles in ’91. Now that the twin bubble machine is shut down the financial sector (which has grown enormous in the past 30 years) needs places to go. And lo and behold, even safe, low yield assets have largely been taken away through QE. What’s more the T-bills markets is nearly ‘full’ (i.e. any more investment yields pathetic returns). The stock markets are down and the real economy is in the dumps. So, money is flying wherever it can. And commodities are one place. (Gold and silver are the most obvious in this regards because there is definitely no fundamental issues — while there may be SOME fundamentals with regard to the others).

    If the current situation is even remotely as I say it is, then monetary policy has shown its contradictions in more pertinent form then perhaps it ever has in history. Indeed, it may be causing as many problems as it is alleviating.

    This brings me back to my original point: you cannot simply look at CPI when you’re talking about inflation today. If you agree that the Fed has no direct means to raise the CPI, then perhaps consider that their monetary maneuvering may be doing as much harm as it is doing good (and there is some good, don’t worry, I do recognise that) — they may be pushing investors into speculative markets and this may be driving down real incomes and profits and furthering the crisis.

    (We should also take into account lost interest income. The Fed noted recently that the life insurance industry and pensions were experiencing shortfalls due to QE. The former effects profits. The latter can have very direct impacts on aggregate demand).

  15. 15 David Glasner January 4, 2012 at 9:27 am

    pilkingtonphil, I am not sure what I said that would lead you to conclude that I am not a market monetarist. I don’t spend much time thinking about whether I am one or not, but on matters of monetary policy, I am in accord with just about everything in their program.

    Thanks for sharing your views on the current economic situation, which I don’t really follow very well, but it gives me something new to think about.

  16. 16 pilkingtonphil January 4, 2012 at 9:39 am

    Think: Richard Koo with the added caveat that very low interest rates in a ‘balance sheet recession’ (http://www.youtube.com/watch?v=HaNxAzLKegU) environment can lead to increased speculative pressures in commodities markets. This eats into real incomes because oil and food costs more etc. The effects on real incomes leads to even less spending being available for other goods and services.


  1. 1 Inflating Peoples’ Pockets | Economic Thought Trackback on December 27, 2011 at 8:24 am
  2. 2 Some Fallacies in the Interpretation of Inflation « Uneasy Money Trackback on December 31, 2011 at 7:47 pm
  3. 3 Interpreting Inflation: A Reply | Economic Thought Trackback on January 9, 2012 at 10:38 am
  4. 4 The Fog of Inflation « Uneasy Money Trackback on January 10, 2012 at 10:30 am

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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